We have heard about Backdoor Roth and it is now a popular strategy. Even I have spoken about it as well as Mega Backdoor Roth before but there is one aspect that stumps most people interested in backdoor Roth approach and sometimes even makes the conversion not worth it. It tends to happen more often to people who are most interested in saving for Roth as they commonly have an IRA account as well. I myself have suffered this issue as I converted my 401K to an IRA when I shifted my job some time ago and very nearly avoided this in my Mega Backdoor Roth conversion.
What is Pro-Rata Rule
The “Pro-Rata” rule refers to how the IRS taxes the movement of “before-tax” and “after-tax” money in your retirement account(s). It is the formula applied to determine how much of a distribution is taxable if an account holder holds both after-tax and pre-tax dollars in an IRA. For this rule, IRS looks at SEP, Simple, and Traditional IRA as one irrespective of whether you have them at multiple administrators. You cannot consider two accounts in separate brokerages as separate for this calculation. e.g. If you have an IRA with Scottrade and another one with Fidelity or Schwab, IRS treats all of them as one IRA.
Let’s take an example to see how these calculation works:
You have two IRA accounts, one at Scottrade and another at Schwab. The details of these accounts are as follows
Step 1 – Add all of your IRAs. This includes SEP and Simple IRAs as well. Roth IRA or any annuity or non-ira based investments and plans are not considered. In above case, the total would be $ 26,000 (with 11,000 Post-Tax and 15,000 Pre-Tax)
Step 2 – Add all after-tax dollars in all IRAs.
Step 3 – Calculate the percentage of after-tax dollars vs total dollars in IRA. So, in above case, it would be 11,000/26,000 (or 42.3%)
Step 4 – Identify the taxable amount using this percentage. e.g. If a distribution of $10,000 was made, the tax-free portion would be 42.3% x $10,000 = $4,230. The remaining portion of the distribution ($5,770) would be taxable at ordinary income tax rates.
How to Avoid Pro-Rata Rule
One way to avoid Pro-Rata rule is that if you have access to a 401K plan that allows incoming Rollovers. IRS treats the balance on 31st of December as the balance to calculate the Pro-Rata calculation. In that case, as long as rest of the IRA was rolled back into a 401K before 31st of December of the year, the Pro-rata rule could be avoided completely for BackDoor Roth.