Take-Away: The IRS treats a Roth IRA conversion as a distribution from the traditional IRA. As such, that means the pro-rata rule applies to distributions from the traditional IRA for purposes of determining how much of that year’s distribution(s) are taxable.

Background: Many advisors now encourage their clients to convert their traditional IRA to a Roth IRA in anticipation of the increase in income tax rates in the coming years. It is this potential increase in the number of Roth IRA conversions that prompts the need to be familiar with the IRS’ pro-rata rule.

Pro-Rata Rule: The IRS’ pro-rata rule has been covered in the past. The pro-rata rule is used to calculate how much of a traditional IRA distribution is taxable, or how much of the IRA owner’s basis is returned to the owner tax-free. This arises when the IRA owner has both pre-tax and after-tax money held in his or her traditional IRA. If the IRA owner only has pre-tax dollars in his or her IRA, you can stop reading this now.

  • Aggregation: The pro-rata rule treats all of the owner’s IRAs as one single retirement account, including SEP and SIMPLE IRAs. All of these traditional IRAs are aggregated and treated as a single IRA. Excluded from this aggregation are only existing Roth IRAs and inherited IRAs. Consequently, when the owner’s traditional IRAs contain both pre-tax and post-tax contributions, some of the distribution will be treated as a taxable distribution, and some of the distribution will be treated as a non-taxable return of basis, regardless of which IRA holds the after-tax contributions.
  • Form 8606: It is the IRA owner’s responsibility, not the IRA custodian’s, to track any after-tax contributions to a traditional IRA. This is accomplished by filing Form 8606 when after-tax contributions are made to a traditional IRA.
  • Cream-in-the-Coffee Rule: The mix of both pre-tax and post-tax contributions in the owner’s IRAs is commonly referred to as the cream-in-the-coffee rule. Once after-tax funds (the cream) are combined with the pre-tax contributions (the coffee) from all of the owner’s aggregated IRAs, every distribution from any one of the owner’s IRAs will include some ‘cream (tax-free) and coffee (taxable).’ This is the case even if only after-tax contributions are made to one traditional IRA and all pre-tax contributions are made to another traditional IRA.
  • Pro-Rata Formula: The calculation of how much of a distribution is taxable, or a non-taxable return of basis, i.e. after-tax contributions, is performed at the end of each calendar year. It is determined on December 31, looking at the aggregation of all of the owner’s traditional IRAs (both pre-tax and after-tax.) Note that the aggregation of the IRA balances is determined on that calendar year-end date, not the date of distribution from an IRA during the calendar year. If an IRA is currently in the process of being rolled over, i.e. in-transit, it too must be included as part of the December 31 aggregated balance of all of the owner’s IRAs.
  • Roth Conversions: As noted above, the IRS treats a Roth IRA conversion as a distribution from a traditional IRA. As such, the calculation of the ‘cream and coffee’ components also includes the Roth IRA conversion distribution for the calendar year.
  • Example: Sharon owns a traditional IRA-#1 worth $90,000 held with one IRA custodian; of that $90,000 amount, $20,000 represents after-tax contributions to IRA-#1. Sharon owns a second traditional IRA-#2 with another IRA custodian with a balance of $10,000, all of which represents pre-tax contributions to IRA-#2. Following the advice of her tax advisor, Sharon converts $20,000 of her IRA-#1 to a Roth IRA on December 1, 2021. Due to the IRS’ pro-rata rule, Sharon cannot ‘cherry-pick’ the after-tax portion of IRA-#1 for purposes of her Roth IRA conversion. Sharon must take the combined balance of both of her IRAs (both pre-tax and after-tax) and add the amount of all 2021 distributions, and conversions. Assuming no growth in Sharon’s IRAs, her December 31, 2021 balances will be $100,000. [IRA-#1, $70,000 + IRA #2, $10,000 + 2021 Roth Conversion, $20,000 = $100,000. Sharon’s total pro-rata percentage will be 20%, i.e. her after-tax contribution of the total amount [$20,000 of $100,000 =20%.] Sharon multiplies her pro-rata percentage against the amount of her 2021 distribution (the Roth conversion amount of $20,000.) Therefore, only $4,000 of Sharon’s Roth conversion ‘distribution’ will be tax-free. The remaining $16,000 of the amount converted to the Roth IRA will be taxable to Sharon.

Mitigating the Pro-Rata Rule:  The impact of the pro-rata rule can be mitigated by reducing the amount of traditional pre-tax IRA dollars by the end of the calendar year in which the Roth IRA conversion takes place. In effect, this will isolate the after-tax basis dollars held in the traditional IRAs. One way to mitigate the pro-rata rule is to move the pre-tax contribution amount in the traditional IRA to a 401(k) plan if that qualified plan accepts ‘roll-ups’ of a participant’s IRAs to the qualified plan. After-tax contributions and Roth IRA dollars cannot be a part of a participant’s ‘roll-up’ to a qualified plan.

  • Example: Jan owns a traditional IRA-#1 worth $30,000 that she plans to fully cash out on July 1, 2021; $18,000 of Jan’s IRA reflects after-tax contributions and $12,000 reflects the earnings on that IRA account. Jan also owns another IRA-#2 which reflects funds that she rolled over from an earlier 410(k) plan years ago; the balance of IRA-#2 is $150,000 as of December 31, 2021. Following the cream-in-the-coffee rule, Jan’s ‘mix’ in her aggregated two IRAs is $180,000 of which only $18,000 is after-tax dollars, or 10% of the total amount. Consequently, if Jan takes a $30,000 distribution on July 1, 2021, she will own income taxes on $27,000 of that $30,000 distribution. However,  Jan’s employer’s 401(k) plan accepts ‘roll-up’ contributions of traditional IRA amounts. Jan transfers IRA-#2 ($150,000) back into her employer’s 401(k) plan. By doing so, 60% ($18,000 divided by $30,000) of her IRA withdrawal will be non-taxable. In short, $18,000, instead of $3,000, will be income tax-free on Jan’s July 1 cash-out. Note that the ‘roll-up’ can be done even after Jan takes her July 1, 2021 distribution; the only requirement is that the ‘roll-up’ to the qualified plan must be completed by the end of 2021. Jan could also mitigate the taxation of her distribution by making qualified charitable distributions if she was over age 70 in order to reduce the pre-tax balance of her IRA.

Conclusion: If an IRA owner, with both pre-tax and after-tax contributions, anticipates making a Roth IRA conversion sometime this year, the owner might want to explore if their employer’s 401(k) qualified plan accepts ‘roll-ups’ of traditional IRA balances. If so, a ‘roll-up’ of some of the IRA owner’s traditional IRA to the 401(k) qualified plan will change the pro-rata ratio that is used to calculate the taxable portion of the anticipated IRA distribution during the calendar year.