The Money Muse

If you’re managing retirement accounts like IRAs and Roth IRAs, you’ve might’ve heard the term “pro rata rule.” While it sounds complicated, it’s an important concept to understand, especially if you’re considering strategies like a backdoor Roth IRA or have multiple IRAs with both pre-tax and after-tax contributions.

The Basics of the Pro Rata Rule

The pro rata rule is an IRS guideline used to determine how much tax you owe when converting or withdrawing money from a retirement account that has a mix of pre-tax and after-tax funds. Essentially, the IRS treats all your IRAs as one combined balance to calculate the taxable portion. This means you can’t choose to convert only your after-tax contributions; any conversion will include a proportional share of pre-tax funds, which are taxable.

How the Pro Rata Rule Works

Let’s say you have two IRAs: one with pre-tax money and one with after-tax contributions. If you decide to convert some of that money to a Roth IRA, the IRS looks at the total amount of all your IRAs and calculates what portion of the conversion is taxable based on the ratio of pre-tax to total IRA funds. The result is that part of your conversion will be taxed, even if you only want to move after-tax contributions.

Why It Matters for Backdoor Roth IRAs

The backdoor Roth IRA is a strategy many high-income earners use to contribute to a Roth IRA despite income limits. It involves:

1. Contributing to a traditional IRA (no income limits apply)
2. Converting those funds to a Roth IRA

However, if you have other pre-tax IRAs, the pro rata rule applies, and some of the conversion will be taxable. This can reduce the effectiveness of the backdoor Roth strategy if you’re not careful.

Strategies to Minimize Taxes Under the Pro Rata Rule

• Move pre-tax IRAs to a 401(k): If your employer plan allows, roll over pre-tax IRA funds into a 401(k) first. That leaves only after-tax contributions in your IRA for conversion.
• Track contributions carefully: Use IRS Form 8606 to record non-deductible contributions and Roth conversions, ensuring you don’t overpay taxes.
• Seek professional advice: Retirement account rules can get tricky, and a tax advisor can help you plan conversions in the most tax-efficient way.

Bottom Line

The pro rata rule may sound intimidating, but it’s just a way the IRS ensures that any Roth IRA conversions account for both pre-tax and after-tax money in your IRAs. Understanding it can help you plan smarter, minimize taxes, and make the most of retirement account strategies like the backdoor Roth IRA.