How to Avoid The Pro Rata Rule With Backdoor and Mega Roth Conversions
A Guide For Navigating The Tax Pitfalls Associated With Roth Conversions
Two of the most beneficial tax planning tools are Backdoor Roth IRA conversions and Mega Backdoor Roth conversions. If done correctly, they are excellent methods for moving pre-tax assets into a Roth account. The downside is that if not properly performed, you might be hit with an unwanted tax liability due to the Pro-Rata Rule.
What is a Backdoor Roth IRA Conversion?
Traditional IRA contributions are either deductible (pre-tax) or non-deductible (after-tax) depending on your level of income. Backdoor Roth IRA conversions are performed by making non-deductible 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.
Example
Let’s say that Billy currently has a Traditional IRA. Over 5 years, he made tax-deductible pre-tax contributions to this account in the amount of $32,500, which grows to $40,000.
Now he is looking to take advantage of backdoor Roth conversions and makes a non-deductible after-tax contribution of $6,500 to his Traditional IRA in hopes of doing a Roth Conversion. When he Makes the Roth conversion of $6,500, some of that amount will end up being taxable since he already has deductible pre-tax contributions in the IRA.
What is a Mega Backdoor Roth Conversion?
The Pro-Rata Rule can also apply within the 401(k) when trying to make a Mega Backdoor Roth conversion. This rule becomes an issue for Mega Roth conversions when there are pre-tax and after-tax dollars within the 401(k). Often when an employee has maxed out their Pre-Tax 401(k) or Roth 401(k) and still wants to put some money into their workplace retirement account, they will make a contribution to the After-Tax 401(k) bucket.
Example
Let’s say Stacy’s salary is $250,000, and she is currently maxing out her Pre-Tax 401(k) contributions at the maximum of $22,500 for 2023 (this is a 9% contribution from her salary). Her employer matches 100% of her contributions up to 6% of her salary for a total of $15,000.
For 2023 the IRS allows maximum annual additions in a defined contribution plan to be $66,000.
This leaves $28,500 that Stacy can still contribute to her 401(k) plan if she would like. Since she has already maxed out her salary deferrals in her Pre-Tax 401(k), she can put this money in as a contribution to the After-Tax 401(k) account.
This After-Tax account is where the Pro-Rata Rule can come into play. Say Stacy puts the $28,500 in the After-Tax account and it grows to $35,000. The $6,500 of growth is viewed by the IRS as pre-tax dollars. This is an issue because now Stacy has both pre-tax dollars of $6,500 and after-tax dollars of $28,500 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 conversions yearly to ensure that the taxable gain in the After-Tax account does not grow too large.
What is the Pro-Rata Rule?
The Pro-Rata rule states that when a Traditional IRA or 401(k) contains both non-deductible after-tax funds and deductible pre-tax funds, each dollar withdrawn or converted from the IRA or 401(k) 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. This is referred to as the Aggregation Rule. 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 401(k) 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 401(k) account, you may owe taxes on the portion of the account from your employer’s matching contribution. The Secure Act 2.0 changed this limitation, but it is still yet to be seen in the majority of 401(k) plans.
How to Avoid the Pro-Rata Rule
In Billy’s example, he already has pre-tax dollars in his Traditional IRA account. To avoid the Pro-Rata Rule, he will first need to remove all the pre-tax money from the account. Typically, the best way to accomplish this is by rolling the pre-tax Traditional IRA balance into your current employer’s retirement plan.
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 whiteout having to pay taxes on the pre-tax dollars.
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.
Need Some Help?
If you’d like some help from a CPA or CERTIFIED FINANCIAL PLANNER (CFP®) advisor regarding this strategy and how it applies to you, the Rhame & Gorrell Wealth Management team is here to help.
Our experienced Wealth Managers can help you review your financial and tax situation and come up with a custom tax optimization strategy going forward.
Feel free to contact us at (832) 789-1100, [email protected], or click the button below to ask a question or schedule your complimentary strategy session today.
IMPORTANT DISCLOSURES:
Rhame & Gorrell Wealth Management, LLC (“RGWM”) is an SEC registered investment adviser with its principal place of business in the State of Texas. Registration as an investment adviser is not an endorsement by securities regulators and does not imply that RGWM has attained a certain level of skill, training, or ability.
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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