The Pro-Rata Rule: A Backdoor Roth Land Mine

There is no bigger proponent of Roth IRAs than yours truly. If compound interest is the 8th wonder of the world, tax-free growth inside a Roth IRA is, to me, the 9th. My blog post, Explaining Backdoor Roth IRAs, remains our most popular post ever (by a long shot) and for good reason. If you have not read this post, or haven’t read it recently, you should take a couple of minutes to refresh your memory before continuing.

One thing you should be aware of if you are considering a backdoor Roth IRA is the pro-rata rule, which is a tax pitfall that can cost you unnecessary income taxes. In Explaining Backdoor Roth IRAs, I touched on this topic and promised to follow up –finally, I’m getting around to keeping that promise!

It’s a common misconception that you cannot use a Roth IRA once your income reaches certain thresholds designed to progressively increase the tax burden on high-income taxpayers. But Roth IRAs are available to you no matter how much you earn. Here are some truths you need to understand:

  • Everyone who has earned income can contribute to a TIRA (Traditional IRA), no matter how much they earn or whether they have a retirement plan at work or whether they are Married Filing Separately (“MFS”).
  • Everyone, however, does not qualify to take a deduction for their IRA contribution. If you can’t deduct your contribution, you have a “non-deductible TIRA”.
  • Anyone with a balance in an IRA, 401k, or 403b can convert those funds to a Roth IRA. However,
    • you will be taxed on any amount you convert from a pre-tax account to a Roth IRA.
    • in most cases, you cannot convert funds from your 401k or 403b until you “separate from service”, i.e. quit, get fired, or retire.
    • you may owe tax on a nondeductible TIRA to Roth conversion if you have money remaining in other “pre-tax” IRA accounts.

That last statement has profound implications for many people who would like to use the backdoor Roth maneuver. Why would the IRS have you pay tax on funds you didn’t get to deduct in the first place? There are two reasons:

  • Growth on investments in nondeductible IRAs are taxed at your top marginal tax bracket when you eventually begin taking distributions from your account. Growth in Roth IRAs is not taxed. And
  • The IRS would prefer that you convert those pre-tax TIRA balances (and pay the tax) before you convert your non-deductible TIRA balances.

To make up for the inequity of converting growth that would have been taxable to growth that will be nontaxable, the IRS requires you to perform a calculation called the “pro-rata” rule, treating all of your IRAs as one big IRA account. When you do a backdoor Roth conversion, you will be taxed on the “pro-rata” percentage of your total pre-tax IRA balances to the total of all of your IRA balances (Roth IRAs are not included for these purposes).

The pro-rata rule is not totally negative. What it does is to force you to pay taxes on part of your pre-tax IRAs when you convert the nondeductible IRA. The amount you pay taxes on is called “basis” and you get credit for this basis if and when you later convert your other pre-tax IRAs. Click here for an example of the pro-rata rule calculation showing:

  • a taxpayer with a pre-tax IRA of $10,000 who does a $5,500 backdoor Roth IRA and then
  • converts the remaining $10,000 the following year.

So, what if you have a pre-tax IRA account and want to make annual backdoor Roth conversions without owing extra tax? You have several options:

  1. Convert your pre-tax IRAs into a Roth IRA and pay the taxes. This is my first choice if you have a small (less than $10k) IRA balance and can afford to pay the taxes.
  2. Roll your IRA into your current employer’s 401k or 403b. Most employers’ retirement plans accept incoming rollovers but check with your SPD (Summary Plan Description) or ask your HR Department. Downsides to doing this are:
    • Your current employer’s plan may have high costs and few good investment choices, and
    • You lose control over your IRA. Once the money is in your employer’s plan, it’s stuck there until you separate from service.
  3. Leave your old 401k/403b’s back at your prior jobs or roll over to your current plan. Same downsides as above.
  4. And my favorite: Set up a SOLO-401k (aka solo-k) with a side hustle, such as moonlighting, consulting, blogging, and so forth. Speaking of side hustles, one of my favorite physician financial bloggers is Passive Income MD and he posted The List of Physician Side Hustles only last week. He has promised to grow the list as readers make suggestions. You might want to bookmark this one.

If you are reading this and you have money in pre-tax IRAs, you may be wondering if it is too late for a backdoor Roth this year. Nope! Michelle has some good news for you in her Timing Your Backdoor Roth Conversions [VIDEO]vlog, Timing Your Backdoor Roth Conversion.

Explaining Backdoor Roth IRAs

When to Convert to a Backdoor Roth IRA

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