If you’re looking to lower your overall taxable income level, you’re probably trying to figure out how to create a Roth conversion strategy. After a lifetime of saving pre-tax money into retirement accounts, it’s worth taking the time to fully explore the Roth conversion process. That way, you can keep more of your tax dollars while taking advantage of the tax-free withdrawals that Roth accounts provide.
But one thing you should understand is the Roth conversion pro rata rule, and how it impacts Roth conversions. This article will explore:
- How IRA and workplace retirement plan contributions work
- How Roth conversions work
- The Roth conversion pro-rata rule
- How the pro-rata rule applies to IRAs
- Unintended tax consequences of incorrectly doing Roth conversions
- Tax planning strategies and opportunities to explore with your tax advisor
But first, a little background information on how IRA contributions and Roth conversions work.
IRA background information
The Internal Revenue Code allows individual taxpayers to make an annual contribution to an individual retirement account (IRA), subject to annual contribution limits. While there are no income limits to being able to contribute to an IRA, there are income limits to the type of IRA your contribution can go into.
Types of IRA contributions
There are several types of IRAs, such as the SEP IRA or the SIMPLE IRA. Those are both workplace retirement plans, and not part of this discussion.
An individual can also have an inherited IRA. However, since you cannot contribute to an inherited IRA, it is not part of this discussion.
For individuals, there are three types of IRA contributions:
Deductible IRA contributions
These are IRA contributions that an account owner can make to a traditional IRA while taking a tax deduction for the contribution on their tax return. This deduction is considered an ‘above the line deduction’ for tax purposes, as it reduces your adjusted gross income (AGI).
You might also hear of a deductible IRA contribution as ‘pre-tax’ money or pretax contributions. There are income limits on the deductibility of IRA contributions for taxpayers who participate in workplace retirement plans.
Since deductible IRA contributions are made to traditional IRA accounts, the earnings grow tax-deferred. However, any qualified distributions of the contribution or earnings are taxed as ordinary income.
Roth IRA contributions
Since Roth contributions are made with money you’ve paid taxes on, they’re referred to as ‘after-tax money.’ There are income limits to being able to contribute to a Roth IRA.
Since the contribution is made to a Roth account, the earnings grow tax-deferred. Qualified withdrawals are made tax-free.
Nondeductible IRA contributions
A non-deductible contribution is a traditional IRA contribution that is made without deducting the contribution on a tax return.
Like a Roth IRA: Non-deductible contributions are made with after-tax money. Qualified withdrawals of the contribution are tax-free.
Like a traditional IRA: Earnings grow deferred in the traditional IRA. Qualified withdrawals of the earnings are taxed as ordinary income.
There are no income limits on nondeductible contributions. So taxpayers who earn too much income to make direct Roth IRA contributions, or who cannot deduct their IRA contributions can still make a non-deductible IRA contribution.
Nondeductible IRA contributions are reported each year on IRS Form 8606-Nondeductible IRA Contributions.
IRA contribution limits & requirements
In 2022, the annual contribution limit to a traditional IRA or Roth IRA is $6,000 per taxpayer ($7,000 if the taxpayer is age 50 or older). The IRA contribution (either to a traditional or Roth IRA account) cannot exceed 100% of earned income.
For married couples, each spouse can contribute as long as one of them is working and has earned income.
For example, Jim and Nancy recently retired. If they both remain retired, they cannot contribute to an IRA (of any kind). However, if Jim picked up a part-time job making $15,000 per year, the could continue to make the maximum IRA contributions.
Regardless of the contribution type, an IRA contribution for a specific year can be made any time during the calendar year. In fact, the contribution can be made as late as the tax filing deadline of the following year (usually April 15).
Workplace retirement plans
Contributions to an employer-sponsored defined contribution plan work in a similar manner to IRA contributions. However, there are some nuances every plan participant should be aware of.
There are two contribution limits to be aware of here.
Employee contribution limit
Internal Revenue Code Section 402(g) establishes an annual contribution limit for elective employee deferrals. This applies to 401(k) plans, 403(b) plans, and the Thrift Savings Plan (TSP). TSP is the elective deferral plan for federal government employees.
These deferrals can be either:
- Pre-tax contribution (traditional)
- After-tax contribution (Roth)
For 2022, this limit is $20,500 per employee. For employees 50 and older, the contribution limit has a $6,500 ‘catch up’ provision, for a total of $27,000.
This limit is simply for employee elective deferrals. This does not include employer contributions to the plan or additional contributions an employee may be eligible to make to their employer retirement plan.
However, there is an overall contribution limit that applies to total contributions to an employer plan.
Overall contribution limit
IRC Section 415(c) allows for a total contribution to an employer plan on an employee’s behalf. This includes:
- Employee elective deferrals, covered under IRC Section 402(g)
- Employer contributions. This might include:
- Matching contributions based on employee elective deferrals
- Non-elective contributions, which are made regardless of whether the employee chooses to make elective deferrals
- Profit-sharing contributions
- Additional contributions an employee might be able to make, if the plan allows for them. This is the basis of the so-called mega-backdoor Roth IRA conversion plan.
For 2022, the Section 415(c) total contribution limit is $61,000. This includes employee elective deferrals, employer contributions (of any kind) and additional after-tax employee contributions.
An employer plan administrator can, but is not required to, allow after-tax employee contributions. If the administrator chooses not to allow after-tax contributions, then the Section 415(c) limit is for elective deferrals and employer contributions only.
Tax treatment of retirement plan contributions & earnings
The tax treatment of workplace retirement plan contributions are similar to that of IRAs. In order to understand some of the tax planning mistakes (and opportunities), it’s worth going into a little detail on each.
Similar to traditional pre-tax IRA contributions, deductible 401k, 403b, and TSP contributions are tax-deductible.
Actually, these employee contributions will be reported on an employee’s IRS Form W-2, in Box 12. 401(k) and TSP contributions will be marked with letter code ‘D,’ while 401(b) contributions will be marked with letter code ‘E.’
Contributions (and earnings on these contributions) are tax-deferred. Qualified withdrawals will be fully taxed at ordinary income tax rates in the year they are made.
Like with Roth IRAs, Roth 401k, 403b, and TSP contributions are after-tax contributions. These contributions will also be reported on a W-2.
Roth 401(k) and TSP contributions are marked with letter code ‘AA’ in Box 12, while Roth 403(b) contributions will be marked with letter code ‘BB.’
Contributions (and earnings on contributions) to a Roth workplace account are tax-deferred. Qualified withdrawals can be made tax-free.
After tax contributions
Finally, after tax contributions (either by the employer or the employee), are not reported in Box 12 on a W-2. They may be reported in Box 14, for informational purposes.
However, the employer is not required to do this. Just like the employer is not required to allow after tax contributions in the first place.
After-tax contributions are not taxed upon withdrawal. For people looking to do mega backdoor Roth IRA conversions, after-tax contributions represent a huge opportunity. Which is best discussed in another article.
However, earnings on after-tax contributions are considered pre-tax and will be taxed upon withdrawal.
How rollovers work
Since you cannot do a Roth conversion within a workplace retirement plan, you must do an IRA rollover first. From there, you would do any Roth conversion that is necessary.
With that said, there are certain nuances to how plan rollovers work. Generally speaking, most people don’t do rollovers from their retirement plan until after they’ve left the company.
While most people understand the concept of rolling a 401k into an IRA, you might be able to roll an IRA into a 401(k). But only if the retirement plan allows you to.
The retirement plan documents must allow for rollovers into the plan. Not all plans do this, so you’ll have to check with your plan administrator.
How Roth conversions work
A Roth IRA conversion is simply the transfer of retirement assets from a traditional IRA into a Roth IRA. The converted amount can be cash, investments, or a combination of the two.
Most financial advisors routinely do Roth conversions for their clients. Usually, the advisor is in the best position to help decide which financial products to transfer as part of the Roth conversion, based on asset allocation and asset location principles.
Also, if they manage their own investments, individual investors can do Roth conversions in their own accounts. Each financial institution has different procedures, so you should check with your custodian for more details.
How Roth conversions are taxed
Roth conversions are taxed differently, based on whether the conversion amount is pretax or aftertax money.
Roth conversions of pre-tax funds are taxed as ordinary income. Pre-tax funds can be either deductible traditional IRA contributions or earnings inside a traditional IRA.
Roth conversions of after-tax funds are not taxed at all. After-tax funds consist of non-deductible contributions only. Earnings on non-deductible contributions inside a traditional IRA are considered pre-tax.
Now that we understand a little about the tax treatment of Roth conversions, we can discuss the pro rata rule.
What is the pro-rata rule?
Actually, since they work hand-in-hand, there are two rules that you need to know about. Those are the pro-rata rule and the IRA aggregation rule.
According to IRC Section 72(e)(8), for tax purposes, an IRA withdrawal will be pro-rated based on the amount of pre-tax money and after-tax money in the account. It also considers a Roth conversion to be a withdrawal from the IRA.
In other words, if you have a traditional IRA with pre-tax money and after-tax money, then you cannot simply ‘withdraw’ the after-tax money and leave the pre-tax money in the IRA. The withdrawal (or Roth conversion) is taxed at the same ratio as the ratio of pre-tax money to after-tax money.
For example, Charlie has $50,000 in his IRA. Of that account balance, $10,000 was from nondeductible IRA contributions (after-tax money), and the rest is pre-tax money (either deductible contributions or tax-deferred earnings).
If Charlie wants to do a $10,000 Roth conversion, he cannot simply take the $10,000 he’s already paid income taxes on, and do a completely tax-free conversion. He must do a calculation.
Since the $10,000 is 20% of the total IRA balance, then 20% of Charlie’s Roth conversion would be tax-free. The remaining 80% would be considered fully taxable ordinary income. In other words, Charlie would pay taxes on $8,000 of his Roth conversion, and convert the other $2,000 without tax consequence.
When I was a practicing financial planner, we did this with an active client by using her TSP account for isolating her after-tax money.
But what if we had two different IRAs–one for after-tax money, and one for pre-tax money? That’s where the IRA account aggregation rule comes into play.
IRA aggregation rule
IRC Section 408(d)(2) states that for the purposes of applying IRC Section 72 (see above), all individual retirement plans count as 1 contract.
In other words, no matter how many IRAs you have, they all count as one for purposes of applying the pro-rata rule.
But Section 408 only applies to IRAs, not employer retirement plans. And that’s where your backdoor Roth conversion planning opportunities lie.
Note: Although SIMPLE and SEP IRAs are employer-sponsored retirement plans, they are actually IRAs, and do count as part of the total balance for aggregation purposes.
Tax planning strategies around the pro rata rule
There are a couple of tax planning strategies that you can use to help mitigate the impact of the pro rata rule. First, you might be able to roll your pre-tax IRA money into your workplace retirement plan. Second, you might be able to use qualified charitable distributions (QCDs) to minimize the tax bite of withdrawing your pre-tax money.
Let’s take a look at the workplace retirement plan option first.
Rollovers INTO a workplace retirement plan
This could be an option for you, if you have a workplace retirement plan that allows it. The concept is fairly simple.
However, there is one caveat. Your employer-sponsored plan has to allow the following rollovers into the retirement plan. Before moving forward, check with your plan administrator or review your summary plan description with your financial advisor.
Let’s assume rollovers into the workplace plan are allowed. If you have a combination of pre-tax and after-tax contributions in your traditional IRA, you can rollover your pre-tax money into your workplace retirement plan.
Remember, your workplace plan is not subject to the IRA aggregation rule or the pro rata rule.
Once you’ve rolled your pre-tax money into your workplace plan, then your traditional IRA contains only after-tax money. From there, you can perform a simple, tax free Roth conversion of the after-tax money.
Bob has $50,000 in his traditional IRA. $25,000 is pre-tax money and $25,000 is after-tax money.
If Bob were to do a $10,000 Roth conversion, he would have to pay taxes on 50% of the conversion under the pro rata rule. However, if he rolls the $25,000 in pre-tax money into his 401(k), he’ll have $25,000 in after-tax remaining in his traditional account.
From there, Bob would be able to do the $10,000 Roth conversion completely tax-free. In fact, he could convert the entire $25,000 with no tax consequence.
After the Roth conversion, you can roll your pre-tax money into your IRA if you want. But there are two things you should consider before you do.
1. Don’t roll your pre-tax money back into your IRA before the end of the tax year.
If you choose to roll the money back into your traditional IRA, you should not do so before the end of the calendar year that you did the Roth conversion. The reason is because of Form 8606-Nondeductible IRAs.
For tax reporting purposes, Form 8606 uses the end of year account balance in performing the pro rata calculation.
So if Bob rolls his pre-tax money back into his IRA in December of the current year, then that pre-tax money will show up on Form 8606. And he’ll be no better off than if he simply did the Roth conversions.
But if Bob waits until January of the following year, then everything reported on Form 8606 will be after-tax money. And tax free.
But there’s another reason you might want to leave that pre-tax money in your workplace plan.
2. You can continue to do backdoor Roth conversions.
If you earn too much money to contribute directly to a Roth IRA, you can always make nondeductible IRA contributions. And if you’re making nondeductible IRA contributions to a traditional IRA that only has pre-tax money, then all of your backdoor Roth conversions will be tax-free.
Wash, rinse, repeat each year. As long as Congress continues to allow it.
But if your employer plan doesn’t allow rollovers into the plan, there might be another option available to you. If you’re at least age 70½.
Qualified charitable distributions
When taxpayers turn age 72, they are required to start taking required minimum distributions (RMDs) from their IRA. One tax planning option for those taxpayers is making qualified charitable distributions (QCDs) from their IRAs instead.
Taxpayers are eligible to make QCDs from their IRA as early as age 70½. Furthermore, QCDs can offset RMDs by up to $100,000 each year.
But the tax planning trick this this: IRC Section 408(d)(8)(D) allows for QCDs to be made with pre-tax money only. So the pro rata rule doesn’t apply to QCDs.
In essence, you can use QCDs to whittle away the amount of pre-tax money in a traditional IRA (or completely draw it down). From there, the remaining money (or a majority of the remaining money) consists of after-tax funds. This would make Roth conversions much more desirable (or even a no-brainer).
Bob is 70½, and retired. He has $50,000 in his IRA ($25,000 pre-tax and $25,000 after-tax). Bob normally contributes $5,000 to his church each year.
Bob will start taking RMDs from his IRA when he turns 72. But what he could do is this:
- Contribute $5,000 from his IRA each year for 5 years. Once he turns 72, the $5,000 would likely be greater than his RMD, so he probably wouldn’t have pay taxes on those withdrawals.
- Once his account consists of only after-tax funds, Bob could then do a tax-free Roth conversion.
Of course, Bob could do Roth conversions earlier (and take advantage of a few additional years of tax-free investment growth). And he could be happy paying some taxes on Roth conversions without creeping into a higher tax bracket.
These are all tax planning opportunities Bob could discuss with his financial advisor.
When creating your Roth conversion strategy, it’s important to keep the pro rata rule in mind. If the pro rata rule might apply to you, there might be a couple of options available to you to lower your tax bill, depending on your tax situation.
As a reminder, this article is for educational purposes only. For in depth exploration of the retirement strategies outlined in this article, you should talk with your tax advisor or financial planner.