The Pro Rata IRA Rule Explained

I recently received the following question from a reader.  It’s a unique situation that you may find interesting, so I thought I’d share the interaction with you:

Here’s my situation, in 2010, I started with the following:

(A) Rollover IRA (from rollover funds back in 2007 with no new funded added since. $157K was rolled over in 2007, but account is now valued at ~$146K).
(B) Roth IRA (that was opened years ago with minimal amount, but no new funds added in the past decade due to income limitation)
(C) Non-deductible (separate) traditional IRA account opened in 2006 with max allowable IRA amount deposited in each year, but have only been depositing NON-DEDUCTIBLE dollars ($4K each in 2006 & 2007, and $5K each in 2008, 2009, 2010 for a total of $23K invested). However, the account was only worth ~$17K/$18K at the time I went to convert)

In early 2010, after making the 2010 contributions, I converted the entire value of the non-deductible traditional IRA account to a Roth IRA.

My question is: since I’ve kept my non-deductible contributions in a separate account and converted to the Roth IRA, am I subjected to the pro-rata rule for taxes due in 2010 even though I have no other IRA account other than the Rollover IRA? I had thought that since I had a “loss” with my non-deductible account, and that I kept the funds separate, I would not, but not sure.

This was my response:

It seems like this would be pretty complex, but it really isn’t too bad if you keep two things in mind:

1) the IRS looks at all of your traditional IRAs (includes rollovers, deductible contributory and non-deductible contributory) as one single balance

2) given #1, you cannot separate deductible and non-deductible amounts when taking distributions

Since a Roth conversion is a distribution, and knowing what we know from #1 & #2 above, part of your conversion would be taxed and part of it would be tax-free – and the amounts would be pro-rated, based upon a calculation factoring your end-of-year balances in all of your IRA accounts, plus any amount that was distributed during the year.

So, if you take the balance of all of your IRAs at the end of the year ($146k) and add the amount of your distribution for conversion ($18k), you come up with a total of $164k (assuming there were no other distributions in 2010).  Of that, you indicated that there was $23k from non-deductible contributions.  Dividing that non-deducted amount by the total we come up with ~14.02% (23k / 164k = .14024).  Of the $18k that you converted, 14.02% or $2,523.60 would be considered tax-free distribution, and the remaining $15,476.40 would be taxable.  (This calculation was done with the very round figures that you provided.  Actual end-of-year 2010 figures must be used to calculate the true pro-rata amounts.)

The good news is that, if you choose, you can spread the tax on your conversion onto your 2011 and 2012 returns.  Or you can just pay the piper on your 2010 return – it’s your call.

And then there was a follow-up from the reader:

Just a few additional follow-up questions for you:

(1) If only a percentage of my distribution is tax-exempt this year, am I not being “double-taxed” (so-to-speak) on the $15,476.40, since this is after-tax dollars that funded the non-deductible traditional IRA?  If I make NO additional conversions or distribution until I reach of age, 59 1/2 (by the way, I’m currently married and in my mid-forties), what amount is tax-exempt when I make the next distributions?  Can I expect $15,476.40 ($18K – $2,523.60)  + $15,476.40 (taxes due this year) = $30,952.80 now considered as non-deductible because taxes have already been paid (50% was non-deductible conversion, the other 50%, taxes paid in 2010)?  Assuming NO new non-deductible funds moving forward, is my “new” non-deductible amount now stand at $30,952.80?

(2) Since my current Roth IRA is UNDER $30,952.80, how can I now correctly earmarked my Rollover account with taxes already paid to $15K so that when it’s time for me to take distribution from that account, I’m not going to be taxed again (!)?  In other word, for argument sake, let’s just say my Rollover IRA does not grow beyond $146K until I’m 59 1/2, can I then use $15,476.40 as non-deductible dollars of my $146K, thereby, only ~$130K is taxable?  Additionally, I would assume that my Roth would now grow tax-free from here-on-in, so any gains is not subjected to taxes.

(3)  Finally, is there any way that I can undo what was converted to my Roth IRA in 2010 before I file my taxes on April 15?  I did the non-deductible to Roth IRA conversion back in Jan 2010.  I did A LOT of research back in 2009 and there was a lot of advice (Suze Orman, Kiplinger, Money Magazine, etc) that stated that if one had non-deductible funds in a separate traditional IRA, that one would be able to make a Roth conversion in 2010 TAX-FREE.  It was touted as a way for those of us who had not been able to make Roth IRA conversions because of income limits to now be able to take advantage of the Roth.  There was not any mention of the Pro-Rata.  It appears that somewhere in 2010,  the pro-rata rule came into play, and now those conversions are not only NOT tax-free, but potentially can be double-taxed!  I can’t quite understand how this can be done so that I’m not being double-taxed on my non-deductible funds.

… and here is my response to the follow-up:

Back to my #1 and #2 – you had total basis of $23k (the non-deductible amount) in all of your IRAs.  With the distribution and the pro-rata taxation, you will have used up $2,523.60 of the $23k.  As you distribute funds from your IRA, each year the rate will adjust to match the new figures.  YOU MUST KEEP TRACK OF YOUR BASIS ON YOUR OWN – no one else will track this for you, unless you have your tax guy do it and then I’d keep my own record anyhow if I were you.

The amount in your Roth account is not considered non-taxable basis for your Traditional IRA.  The balance of your Roth IRA is classified as:  amounts you’ve contributed, amounts you’ve converted, and growth on the value of the first two amounts.  The only figure that’s important to track is the total of the amount you contributed or converted, since if you begin taking distributions before age 59½ you’ll need to know how much has already been taxed.  Early distributions from the Roth account are not subject to a pro-rata rule – your taxed contributions and conversions come out first, then growth last.

You can re-characterize the Roth conversion at any time before October 15 – but it would be simplest if you did this before April 15.  This will essentially put your money back into the traditional IRA and the IRS treats the situation as if nothing happened.

After my response, the reader replied:

I’ve been researching the re-characterization, but have a couple more questions:

(1) The Roth conversion without income limit, can that be conducted in 2011 and onward, or was this just for 2010 only?

(2) If answer to #1 above is yes, can I roll all the deductible portion, $130K of my Rollover IRA (i.e. $146K – ~$16K = $130K) to my current Employer’s 401K, and then convert the $16K tax-free to my Roth IRA this year since I would have paid taxes on this on 4/15/11?  Tracking the non-deductible versus deductible seems too complicated — can I just do it this way?  That way, outside of the company’s 401K plan, I’d only have a Roth IRA and zero balance in a non-deductible IRA?

To which I responded as follows:

1 – yes, the income limit was eliminated beginning in 2010 and will remain so for the foreseeable future

2 –As I read the code it seems to me that such a move would work.  This would be one way of getting around the problem with your conversion/taxation – re-characterize your conversion from 2010, rollover the monies from the deductible account to your 401(k), and then convert the monies from the non-deducted account to Roth.  The biggest problem with this is getting the 401(k) plan to accept the roll-in of your IRA.

About the author

Jim Blankenship, CFP®, EA

Jim Blankenship is the founder and principal of Blankenship Financial Planning, Ltd., a financial planning firm providing hourly, as-needed financial planning and advice. A financial services professional for over 25 years, Jim is a CFP professional and has earned the Enrolled Agent designation, a designation that qualifies him as enrolled to practice before the IRS. Jim is also a NAPFA-registered financial advisor, which designates him as a Fee-Only Financial Advisor.

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