Backdoor Roth IRA conversions are an attractive option for some higher-income individuals who want to make the most of their retirement savings. However, the Roth conversion pro-rata rule tends to be something many overlook or otherwise fail to consider for this option in financial planning.
If you have been building up your traditional IRA or 401k plan, the Roth conversion pro-rata rule can actually make the conversion less efficient. The idea behind a strategic Roth conversion is for you to get the most advantage of the many potential benefits. This would include no taxes on withdrawals and no required minimum distributions.
What is the Pro-Rata Rule for Roth Conversions and How Does It Work?
The IRA pro-rata rule for Roth conversion applies when you take pre-tax retirement funds from your traditional IRA or 401k plan and convert it into a Roth IRA. This is typically done because higher-income individuals don’t qualify for a Roth IRA due to income limits. The workaround for this is a backdoor Roth conversion, which allows for the conversion of existing retirement assets into a Roth IRA.
The backdoor Roth conversion pro-rata rule states that when you convert a part of your traditional IRA or 401k plan, the taxable amount is determined on a pro-rata basis. This means that the taxable amount is proportional to the ratio of your pre-tax and after-tax balances in your IRA.
Roth IRAs are always funded with after-tax dollars, so most assume that moving tax-deferred money to a Roth IRA would mean you only pay taxes on the converted amount. However, this is only the case if your Roth IRA contributions were non-deductible contributions from your other IRA accounts or 401k plan.
If you never contributed after-tax money to your 401k or a traditional IRA, then the total conversion to your Roth IRA will be taxed at your normal tax rate. If your traditional IRA contributions contain deductible and non-deductible contributions, the backdoor Roth IRA conversion pro-rata rule applies.
How Do You Calculate the Pro-Rata Rule for Roth Conversions?
The Roth conversion pro-rata rule aggregates all the money you have in your IRA when you make a conversion. To do this you, will need to know the percentage of non-taxable funds. You can make that calculation this way:
- Non-taxable percentage = Non-deductable funds / Total balance across all non-Roth IRA accounts
Once you have this information, you can determine how much after-tax funds will be converted to your backdoor Roth IRA:
- After-tax funds in Roth conversion = amount to be converted to Roth IRA × non-taxable percentage
What Challenges Can You Face with the Pro-Rata Rule?
With a large conversion of funds to a Roth account, there would be a substantial amount of taxes you need to pay upfront. Be mindful of the taxes you may owe. Having such a hefty tax bill might not be in your best interest.
Always make sure you have the proper financial plans in place to actually make use of and benefit from the offerings of a Roth IRA. If you aren’t sure about whether or not a backdoor conversion is right for you, consult with a financial advisor on how the Roth conversion pro-rata rule can affect you.
What Are Alternatives to a Backdoor Roth IRA for Tax-Free Growth?
The Roth conversion pro-rata rule can be a deterrent for some who want the benefits of tax-free growth, but aren’t eligible for a Roth IRA. However, some employers can give you access to plans like a Roth 401k.
A Roth 401k is similar to a traditional 401k in that both are employer-sponsored, but the difference is the tax treatment. The contributions you make to Roth 401k are done with after-tax dollars, much like with a Roth IRA. This can be a great alternative for you if you were interested in creating a backdoor Roth IRA as a high-income individual.
However, each type of retirement plan has its advantages and drawbacks. A Roth 401k still has required minimum distributions which you must take to avoid penalties. On the other hand, a Roth 401k has employer-matching contributions, and your beneficiaries who inherit a Roth 401k can still enjoy qualified tax-free withdrawals.
Whether or not this is an option for you to opt out of a Roth conversion and pro-rata rule will be based on your unique financial situation and goals. It’s always best to seek the appropriate guidance on how to move forward with the best plan for your financial future.
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A Roth conversion may not be suitable for your situation. The primary goal in converting retirement assets into a Roth IRA is to reduce the future tax liability on the distributions you take in retirement, or on the distributions of your beneficiaries. The information provided is to help you determine whether or not a Roth IRA conversion may be appropriate for your particular circumstances. Please review your retirement savings, tax, and legacy planning strategies with your legal/tax advisor to be sure a Roth IRA conversion fits into your planning strategies.
Any comments regarding safe and secure investments and guaranteed income streams refer only to fixed insurance products. They do not refer in any way to securities or investment advisory products. Fixed insurance and annuity product guarantees are subject to the claims paying ability of the issuing company; not guaranteed by any bank or the FDIC.
Stewart Willis is the founder and president of Asset Preservation Wealth & Tax, a financial planning firm in Phoenix, Arizona. Investment advisory services offered through Foundations Investment Advisors, LLC, an SEC registered investment adviser.
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