Few things seem to generate more confusion than the Pro-Rata Rule.
It’s time for the FI Tax Guy to tackle it head on!
The Rule
For all the confusion about the Pro-Rata Rule, it is actually a very simple rule. All the Pro-Rata Rule says is that IRA Basis is allocated between two things.
One thing is IRA distributions and Roth conversions occurring during the year. The second thing is balances in traditional IRAs, SEP IRAs, and SIMPLE IRAs as of December 31st of the year.
If you understand the three bolded concepts, none of which are rocket science, you can easily master the Pro-Rata Rule.
The Pro-Rata Rule means that taxpayers can’t “cherry pick” to say that all of a distribution or Roth conversion goes against existing basis if there are traditional/SEP/SIMPLE IRA balances at year-end. Rather, that IRA Basis is proportionately allocated, based on value, between the distributions and Roth conversions on one hand and year-end balances on the other.
IRA Basis
IRA Basis exists to ensure amounts that were never deducted on their way into a traditional retirement account are not taxed on the way out.
As I previously wrote, IRA Basis emerges from two sources. The first is nondeductible traditional IRA contributions. These are reported on Form 8606 filed with one’s annual federal income tax return.
IRA Basis is to the Backdoor Roth IRA what the flux capacitor is to time travel: it’s what makes it possible.
Nondeductible Traditional IRA Contributions
Here’s an example of how a nondeductible traditional IRA contribution creates IRA Basis:
Example 1: Emmett contributed $6,500 to a nondeductible traditional IRA on January 2, 2023. At that time and on December 31, 2023, Emmett had no other balances in traditional IRAs, SEP IRAs, and SIMPLE IRAs. That $6,500 contribution creates $6,500 of IRA Basis. On February 1, 2023, Emmett converted the entirety of his traditional IRA, then $6,505, to a Roth IRA. Emmett did a successful Backdoor Roth IRA, and as a result, just $5 is taxed to him ($6,505 minus $6,500) since he recovers the $6,500 of basis created by the nondeductible traditional IRA contribution when determining the taxation of the Roth conversion.
Here is Part I of Emmett’s Form 8606 and here is Part II. Note that tax return software programs may not complete Part I but instead present it as a worksheet or statement.
In terms of the Pro-Rata Rule, 100% of Emmett’s $6,500 IRA Basis was allocated to his IRA distributions and Roth conversions during the year and 0% of Emmett’s $6,500 IRA Basis was allocated to his traditional/SEP/SIMPLE IRA balances on December 31st, since Emmett had no basis in traditional IRAs, SEP IRAs, and SIMPLE IRAs as of December 31st.
After-Tax Contributions to Workplace Retirement Plans
The second source of IRA Basis is after-tax contributions to workplace retirement plans. These are not deducted when made.
I’ve seen these occur in two contexts, though there are others. The first is after-tax 401(k) contributions, which oftentimes are done as part of a Mega Backdoor Roth IRA. Note that Mega Backdoor Roths exhaust the basis. The second context is a mandatory 401(a) plan. These are retirement plans sometimes offered by nonprofit organizations (educational institutions, hospitals, etc.). These plans sometimes require employees to make after-tax contributions to the retirement plan.
Transfers of after-tax basis in workplace plans to traditional IRAs create IRA Basis. However, in today’s environment, after-tax contributions not used up by Mega Backdoor Roths should not end up in traditional IRAs. Rather, they should end up in Roth IRAs under the rules available under Notice 2014-54. I discussed moving workplace after-tax contributions to Roth IRAs in this post.
IRA Distributions and Roth Conversions During the Year
This the second concept to understand: IRA distributions and Roth conversions during the year. These are reported to the IRS and taxpayers annually on a Form 1099-R.
The tax law treats all IRA distributions and Roth conversions as a single combined distribution for purposes of applying the Pro-Rata Rule.
This number is computed based on the relevant year. Unlike an IRA contribution, distributions or Roth conversions made after year-end cannot be designated as being for the current year.
Distributions and Roth conversions from qualified workplace retirement plans (such as 401(k)s) are not included in this number.
Rollovers and other transfers that end up back inside a retirement account are not included in this number.
Traditional IRA, SEP IRA, and SIMPLE IRA Balances on December 31st
Only one day matters! December 31st!
Financial institutions report to both the IRS and the taxpayer their year end traditional IRA, SEP IRA, and SIMPLE IRA balances on a Form 5498.
Amounts in qualified workplace retirement plans (such as 401(k)s) are not included in this number, though SEP IRAs and SIMPLE IRAs are included in this number.
As you can see on line 6 of the Form 8606, you must include “outstanding rollovers” in your December 31st balance. Without this rule, people could avoid the Pro-Rata Rule by taking a distribution from their IRA late in the year and refunding it (within 60 days) early the following year, essentially hiding the money from the December 31st balance amount.
Pro-Rata Rule FAQ
Do I Need To Be Worried About the Pro-Rata Rule?
Yes but only if (1) you take (or consider taking) a traditional IRA, SEP IRA, and/or SIMPLE IRA distribution or convert (or consider converting) an IRA to a Roth IRA and (2) you have IRA Basis.
If either or both do not apply to you, the Pro-Rata Rule has no relevance to your financial life.
Does the Pro-Rata Rule Apply for Purposes of Assessing the 10% Early Withdrawal Penalty?
Yes, but see the Roth conversion paragraph below.
The early withdrawal penalty does apply to regular withdrawals from traditional IRAs, SEP IRAs, and/or SIMPLE IRAs if the account owner is under age 59 ½. The amount of basis recovered under the Pro-Rata Rule is relevant, since only the taxable portion of the IRA distribution can be subject to the 10% early withdrawal penalty.
Note that exceptions to the 10% early withdrawal penalty can apply if one is under age 59 ½, including but not limited to 72(t) payments.
If the transaction is a Roth conversion, the 10% early withdrawal penalty does not apply, regardless of age, so it doesn’t matter how much of the Roth conversion is taxable. The 10% early withdrawal penalty simply never applies.
What Are the Exceptions to the Pro-Rata Rule?
The Pro-Rata Rule applies to nearly all movements of assets out of traditional IRA, SEP IRA, and SIMPLE IRAs. However, there are exceptions.
- Transfers from IRAs to qualified plans such as 401(k)s (I wrote about this rule in this post, see Steps 2 and 3 of the Case Study)
- Qualified charitable distributions (QCDs)
- Qualified HSA funding distributions (QHFDs)
If any of the above three apply, IRA Basis stays behind in the IRA and is not diminished by the transaction. The Pro-Rata Rule does not apply to these three transactions.
The Pro-Rata Rule also has no application to nontaxable rollover distributions of IRA assets (i.e., distributions that wind up back in IRAs).
I Have an Old Traditional 401(k) (No Basis) That I Rolled to a Separate Traditional IRA. That Doesn’t Count for Pro-Rata Rule Purposes, Correct?
Incorrect!
The Internal Revenue Code is quite clear: all traditional IRAs, SEP IRAs, and SIMPLE IRAs are aggregated and treated as a single traditional IRA for purposes of applying the Pro-Rata Rule. The rules don’t care about the origin of the IRA.
I Inherited a Traditional IRA from My Father and Inherited a Traditional IRA from My Aunt. They Both Had IRA Basis. Does That Basis Get Added to My Own IRA Basis?
No!
However, that basis goes with each inherited IRA. Each inherited IRA is hermetically sealed. So IRA Basis inherited from your father attaches only to the IRA inherited from your father. The IRA Basis inherited from your aunt only attaches to the IRA inherited from your aunt. Those two IRA Bases are not commingled. See Natalie B. Choate’s treatise Life and Death Benefits for Retirement Planning (8th Ed. 2019), page 151.
Isn’t the Pro-Rata Rule a Bad Rule That Should be Repealed?
Mostly no.
The Pro-Rata Rule reasonably sets forth how basis is recovered when withdrawing or converting money. Allowing taxpayers to “cherry pick” but having distributions or conversions access IRA Basis fully before accessing taxable amounts could make RMDs nontaxable to start off (effectively increasing the delay in taxation of deferred retirement accounts).
I believe the answer to eliminate Pro-Rata Rule confusion is to eliminate nondeductible contributions to retirement accounts, as I discussed in proposal number 5 of my retirement tax reform proposal.
Once there are no more after-tax contributions to retirement accounts, there’s no more IRA Basis. Once there’s no more IRA Basis, there’s no need for the Pro-Rata Rule.
Is the Pro-Rata Rule Applied Differently to Roth Conversions Than It Is to Regular IRA Distributions?
No difference whatsoever.
I will add one quick point: IRA distributions can be subject to the 10% early withdrawal penalty (as discussed above) while Roth conversions can never be subject to the 10% early withdrawal penalty, so as applied to regular IRA distributions the Pro-Rata Rule can be more impactful (since recovered basis avoids both ordinary income tax and the 10% early withdrawal penalty). But the application is the exact same.
Pro-Rata Rule Example
Since I’m writing this at year-end, I’ll borrow from some of my previous work in providing this example.
Example 2: Joe contributes $6,500 to a nondeductible traditional IRA on January 2, 2023. On February 1, 2023, when the traditional IRA is worth $6,505, Joe converts the entire balance to a Roth IRA. On December 31, 2023, Joe had $80,000 in an old traditional IRA (a rollover of an old 401(k)). That IRA has no basis.
The Pro-Rata Rule applies here to say “Okay, Joe has $6,500 in IRA Basis. How do we divide that up between (1) Joe’s $6,505 Roth conversion and (2) Joe’s $80,000 December 31st traditional IRA balance?”
The Pro-Rata Rule divides that amount proportionally based on the value of those two things. When we add $6,505 to $80,000 we get $86,505. The Roth conversion is 7.52% of the combined total ($6,505 divided by $86,505) and the December 31st IRA balance is 92.48% of the combined total ($80,000 divided by $86,505).
Thus, the Roth conversion attracts 7.52% of the IRA Basis ($489) and the December 31st IRA balance attracts 92.48% of that IRA Basis ($6,011). As a result, $6,016 of the Roth conversion is taxable ($6,500 minus $489) and Joe will go into 2024 with $6,011 of IRA Basis.
Here is Part I of Joe’s Form 8606 and here is Part II.
Watch me discuss how to compute the Pro-Rata Rule in Google Sheets.
More Pro-Rata Rule Posts
The Pro-Rata Rule has a significant impact on Backdoor Roth IRA planning. I cover that in these three posts:
Backdoor Roth IRAs for Beginners
What to Do if You Don’t Qualify for a Backdoor Roth IRA
The Backdoor Roth IRA and December 31st
Basis Isolation planning can be very impactful and help avoid taxation under the Pro-Rata Rule. I discussed that planning here.
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This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.