When does it Apply?
Two of the most beneficial tax planning tools are Backdoor Roth conversions and Mega Backdoor Roth conversions. They are excellent methods to move assets into a Roth account if set up and used correctly. The downside is that if not done correctly or if not properly performed, you might be hit with an unwanted tax liability due to the Pro-Rata Rule.
Backdoor Roth conversions are performed by making nondeductible after-tax contributions to a Traditional IRA account and then rolling those into a Roth IRA account. If you already have tax-deductible pre-tax contributions in your Traditional IRA and try to do a backdoor Roth conversion, you might get hit with an unwanted tax bill due to the pro-rata rule. Let’s say that Billy currently has a Traditional IRA that he has made tax deductible pre-tax contributions to in the amount of $30,000. Now he is looking to take advantage of backdoor Roth conversions and makes a non-deductible after-tax contribution of $6,000 to his Traditional IRA in hopes of doing a Roth Conversion. When he Makes the Roth conversion of $6,000, some of that amount will end up being taxable since he already has deductible pre-tax contributions in the IRA.
Another common scenario would be trying to make a Mega Backdoor Roth conversion. The pro-rata rule becomes an issue when making this conversion when a Traditional 401K account in which an employee has contributed on both a pre-tax and post-tax basis. Often when an employee has maxed out their pre-tax Traditional 401K or Roth 401K and still wants to put some money into their workplace retirement account, they will make an after-tax Traditional 401K contribution.
Let’s say Tosh’s salary is $250,000, and she is currently maxing out her pre-tax 401K contributions at the maximum of $20,500 for 2022 (this is an 8.2% contribution from her salary). Her employer matches 100% of her contributions up to 6% of her salary for a total of $15,000. For 2022 the IRS allows maximum annual additions in a defined contribution plan to be $61,000. This leaves $25,500 that Tosh can still contribute to her 401K plan if she would like. Since she has already maxed out her salary deferrals in her Traditional pre-tax 401K, she can put this money in as an after-tax contribution. This after-tax account is where the pro-rata rule can come into play. Say Tosh lets the $23,500 in the after-tax account grow to $32,000. The $6,500 of growth is viewed by the IRS as being pre-tax dollars. This is an issue because now Tosh has both pre-tax dollars of $6,500 and after-tax dollars of $23,500 in the same account. The $6,500 of pre-tax dollars will have to be realized as income when a Mega Backdoor Roth conversion is made. Therefore, it is best to make your Mega Backdoor Roth conversion yearly to ensure that taxable gain in the after-tax account does not grow too large.
What is it?
The pro-rata rule states that when a Traditional IRA or 401K contains both non-deductible after-tax funds and deductible pre-tax funds, each dollar withdrawn or converted from the IRA or 401K will contain a percentage of tax-free and taxable funds relative to the proportion those funds make up the account. This ratio is calculated based on the percentage of after-tax dollars in Traditional IRAs, SEP IRAs, and SIMPLE IRAs.
It is important to note that the pro-rata rule treats all IRAs as one IRA. Opening a new IRA account and making a nondeductible contribution does not avoid this rule. Another common wrinkle is that even if you contribute to an after-tax 401K through your employer, the employer match of your funds must be placed in a non-Roth account. This means that if you try to convert your entire 401K account, you may owe taxes on the portion of the account from your employer’s matching contribution.
How to Avoid
In Billy’s example, he already has pre-tax money in his Traditional IRA account. To make his non-deductible after-tax contribution, he will first need to remove all the pre-tax money from the account. This can be done by rolling the Traditional IRA balance to your current employer’s retirement account. When doing this, consult your current company’s employer plan to make sure they handle this transaction correctly. Once your Traditional IRA has been zeroed out, you are ready to make your backdoor Roth Conversions.
Mega Backdoor Roth conversions have many moving pieces and, if done incorrectly, can land you a massive tax bill. Please consult our article about Mega-Roth Strategies for more information on navigating them, or please feel free to call our team at Rhame and Gorrell to have your questions answered.
Rhame & Gorrell Wealth Management, LLC ("Rhame & Gorrell" or "the Firm") is an SEC registered investment adviser with its principal place of business in the State of Texas. Registration does not imply a certain level of skill or training.
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own CPA or tax professional before engaging in any transaction. The effectiveness of any of the strategies described will depend on your individual situation and should not be construed as personalized investment advice.
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