Revisiting the ‘Pro-Rata’ Rule with Respect to ‘Backdoor’ Roth IRA Conversions

Many federal employees are attempting to convert as many of their traditional retirement accounts – in particular, traditional IRAs – to Roth IRAs. The main reason behind the incentive to convert is to take advantage of the current low federal marginal individual tax rates that are expected to increase during the next five to ten years.

When a traditional IRA is converted to a Roth IRA, federal and state income taxes will have to be paid on any portion of the traditional IRA that has not been taxed. This portion includes IRA contributions that were deducted and tax-deferred accrued earnings within the traditional IRA.

A deductible traditional IRA is one in which the contributions appeared on the IRA owner’s federal income tax return in the year of contributions as an “adjustment to income”, thereby resulting in current savings. There is also a nondeductible traditional IRA that any individual, no matter the individual’s age, income level and whether the individual participates in a retirement plan, is allowed to contribute to.

With a nondeductible traditional IRA, the owner uses after-taxed dollars to contribute to the IRA. As such, the IRA owner does not receive any tax benefit in the year of contribution. Instead, the IRA owner must report the contribution as nondeductible on his or her federal income tax return on IRS Form 8606 (Nondeductible IRAs), thus establishing a “cost basis” in the traditional IRA.

When performed correctly, a nondeductible traditional IRA can be converted to a Roth IRA and no income tax has to be paid. This is called a “back-door” Roth IRA conversion. Rather than contributing directly to a Roth IRA in which an individual may not be eligible (because of the individual’s too high income, thus coming via the “front-door”), the individual instead converts the nondeductible traditional IRA to a Roth IRA (which any individual is eligible, no matter their age, whether or not they participate in employer-sponsored retirement plan, and the amount of their annual income).

Background of the “Pro-rata” Rule

When an IRA owner contributes to a nondeductible traditional IRA and reports the contribution on IRS Form 8606 (Nondeductible IRAs), the IRA owner has established a “cost basis” in the IRA. Since the accrued earnings in the IRA are not taxed until they are withdrawn from the IRA, the accrued earnings have a zero-cost basis, and therefore fully taxable when withdrawn.

The “pro-rata rule” is used to calculate how much of a traditional IRA distribution is taxable when a traditional IRA owner has both before-taxed and after-taxed monies in their traditional IRA. The rule is also used in determining how much of a traditional IRA is taxable when it is converted to a Roth IRA. That is, how much of any individual’s “cost basis” is returned. Only traditional IRA owners who have after-taxed contributions in at least one of their traditional IRAs will be affected by the pro-rata rule.

The pro-rata rule treats all of an individual’s traditional IRAs as one big IRA account. This big IRA account includes SEP IRAs and SIMPLE IRAs, as well as IRAs held at different financial institutions are aggregated. Not included in this aggregation of IRAs are Roth IRAs and inherited IRAs (also known as “death” IRAs).

As a result of this mandatory aggregation of IRAs, an individual who owns a mixture of deductible (“before-taxed” contributions) IRAs cannot simply take a tax-free distribution of the after-taxed contributions. Instead, each distribution is treated as consisting partly of before-taxed (taxable) IRA monies and partly of after-taxed (nontaxable) IRA monies.

Note that when an individual owns traditional IRAs made up entirely of before-taxed contributions (this includes contributory IRAs, rollover IRAs, SEP IRAs and SIMPLE IRAs), the pro-rata rule has no applicability, and the entire IRA distribution or Roth IRA conversion is fully taxable.

Understanding the Pro-rata Formula

The following is a copy of part of the 2020 IRS Form 8606 (Nondeductible IRAs) which will help understand the pro-rata formula.

The pro-rata calculation is performed using the appropriate IRA balances as of December 31 of each calendar year. The pro-rata rule covers all traditional IRA distributions made during the previous year. This includes traditional IRA distributions and Roth IRA conversions.

There are four steps involved in the “pro-rata rata” formula process resulting in the determination of the taxable and nontaxable portions of a traditional IRA distribution or Roth IRA conversion. Note that the pro-rata calculation is performed using the appropriate IRA balances as of the end of calendar year (December 31) and covers all traditional IRA distributions made during that year. These steps are detailed below.

Step 1. The balance of all traditional IRAs, both before-taxed and after-taxed, are aggregated and added to the amount of distribution or Roth IRA conversion performed any time during the calendar year. Note that the aggregated balance is determine as of December 31 of the year of distribution, not as of the date of the distribution or conversion. Entered on Form 8606, line 6 (see 2020 Form 8606 above)

Step 2. Total all contributions made during the years (before 2020) to nondeductible traditional IRAs. The total should be entered on Form 8606, line 2 (see 2020 Form 8606 above). If a nondeductible IRA contribution was made for the year 2020, it should be listed on Form 8606 line 1. Line 1 and Line 2 should be added showing the total on Line 3.. (An adjustment will have to be made if a 2020 nondeductible traditional IRA contribution was made between 1/1/2021 and 5/17/2021).

Step 3. Compute the pro-rata percentage of after-tax dollars by dividing Form 8606 Line 3 (or Line 5) by Form 8606 Line 6 and show the result on Form 8606 Line 10 (see above).

Step 4. The nontaxable portion of calendar-year distributions (and conversions) is determined by multiplying the Step 3 percentage by the amount of the distribution or conversion. The remaining portion of the distribution is taxable income. Entered on Form 8606 Line 11 (see 2020 Form 8606 above).

The following example illustrates:

Example 1. Karen has a traditional IRA with Brokerage A. that is worth $120,000 This traditional IRA includes $30,000 of nondeductible contributions (after-taxed contributions, “cost basis”). She also has a $50,000 traditional IRA with Brokerage B that she directly transferred from a 401(k) qualified retirement plan she used to participate in. The “rollover” traditional IRA consists entirely of before-taxed money. In order to take advantage of the current law federal tax rates, on Dec. 15, 2020 Karen converts $30,000 of her IRA with Brokerage A to a Roth IRA. She believes that her conversion will be entirely tax-free. But the “pro-tata” rule prevents Karen from simply “cherry-picking” the after-taxed dollars for a tax-free conversion.

Based on Step 1, Karen must total the balance of all IRAs (both before-taxed and after-taxed) required to be aggregated and add the amount of all 2021 distributions and Roth IRA conversions. Karen’s account saw no growth between her conversion date of Dec. 15, 202 and Dec. 31, 2020.

Her Dec. 21, 2020, balances for Step 1 are:
IRA (custodian A): $90,000
IRA (Custodian B): $50,000
2020 Roth Conversion: $30,000
Total: $170,000

Step 2 requires Karen to total her ‘cost basis” (after-taxed dollars) in all her IRAs. This is $30,000.
In Step 3, Karen computes her pro-tata percentage to be:

$30,000/$170,000 = 17.65%

The “pro-rata” rule only allows a portion of each distribution (or conversion) to come out tax-free.
Step 4 requires Karen to multiply her $30,000 conversion by her pro-rata percentage of 17.65%:

17.65% of $30,000 = $5,294

Therefore, only 17.65% of the $30,000, or $5,294, of her Roth IRA conversion will be tax-free and the remaining $24,706 will be taxable. As of Dec. 31, 2020, Karen has used up $5,294 of her $30,000 IRA “cost basis”.

What About “Isolating” the IRA Cost Basis?

As discussed above, an individual’s aggregated IRA account balance is determined as of December 31 of the year of the traditional IRA distribution or Roth IRA conversion. It therefore makes sense that the impact of the pro-rata rule can be lessened by reducing or eliminating the amount of the traditional before-taxed dollars by December 31. But how can this be done?

For federal employees who own traditional TSP accounts, one way to lessen the amount of “before-taxed” IRA accounts (called “isolating” the cost basis) is by directly transferring before-taxed IRA funds to their traditional TSP accounts no later than December 31 of the year in which the traditional IRA distribution or Roth IRA conversion occurs. The following example illustrates.:

Example 2. Sandy is a federal employee with a traditional TSP account. She owns a traditional IRA (IRA A) that she wants to convert to a Roth IRA on July 1, 2021. IRA A consists of $18,000 of after-taxed contributions and $12,000 of earnings (total value $30,000). She also owns a ‘rollover” traditional IRA (IRA B) that she rolled over from a 401(k) plan that she previously contributed to while working for another employer. The “rollover” IRA (IRA B) is worth $150,000 as of July 1, 2021. Sandy wants to convert IRA A to a Roth IRA. Sandy considers isolating her “cost basis” before converting IRA A to a Roth IRA:

Total value of Sandy’s IRAs: $30,000 + $150,000 = $180,000
Total “cost basis” of Sandy’s IRA = $18,000

“Pro-rata” percentage = $18,000/$180,000 = 10 percent

If Sandy does not isolate her cost basis, then if she converts her $30,000 IRA A, then only 10 percent of the $30,000 IRA or $3,000 will be nontaxable. The other $27,000 will be taxable.

If Sandy transfers her $150,000 “rollover” traditional IRA B to her traditional TSP account (using Form TSP-60), before she converts IRA A to Roth IRA, then her “pro-rata” percentage is:

$18,000/ ($30,000 + $0) = 60 percent
When she then converts her $18,000 IRA A to a Roth IRA, 60 percent of $30,000, or $18,000 will be nontaxable and $12,000 will be taxable.

Sandy could have transferred her rollover traditional IRA B to her TSP account after she performed her Roth IRA conversion, as long as the transferred occurred before December 31, 2021.

In addition to transferring her rollover traditional IRA to her traditional TSP in order to “isolate” cost basis, Sandy could have made a qualified charitable distribution (QCD) only if she was at least age 70.5. Or she could contribute to a qualified Health Savings Account (HSA), assuming has an HSA. This is a one-time direct transfer from a traditional IRA to an HSA.

Finally, it is important to note that an IRA custodian will not determine the taxable and nontaxable portion of a traditional IRA distribution or a Roth IRA conversion. It is up to the traditional IRA owner to track “cost basis” by filing IRS Form 8606. Form 8606 incorporates the pro-rata formula and determines any basis remaining at the end of the year.