Backdoor Roth IRA Conversions: Beware the Pro Rata Rule

Despite the unknown future of backdoor Roth IRAs, they remain a viable instrument in an advisor's toolkit. We asked advisors what they saw as the main dangers of backdoor Roths, and the consensus was clear: misunderstanding the pro rata rule.

The pro rata rule stipulates how the Internal Revenue Service will treat pretax and after-tax contributions when the client does a Roth conversion.

Contributions to traditional IRAs are typically pretax, meaning funds are taxed when withdrawn.

Roth IRA contributions, by contrast, are taxed before entering the account, and investment growth is tax-free.

However, Roth IRA contributions are subject to income and contribution limits. For 2022, investors with modified adjusted gross income of less than $129,000 for individual filers and $204,000 for couples can make full contributions of $6,000 (or $7,000 if they're 50 or older).

Contribution limits are phased out for higher earners; none are allowed for individuals with MAGI above $144,000 or couples earning more than $214,000.

But higher earners can use the "backdoor" Roth strategy: After-tax funds in a traditional IRA can be converted to Roth, and earnings on that money won't be taxed.

Enter the Pro Rata Rule

The pro rata rule kicks in when an investor has both pretax and after-tax money in a traditional IRA.

Any commingling of these funds causes the pro rata rule to kick in. Clients may believe that just the after-tax money they put into the IRA can be converted. In reality, a pro rata formula applies — which means a portion of pre-tax funds move as well, and taxes are due upon conversion. Further, this formula applies for all future conversions.

"The pro rata rule simply says in general, if you have after-tax money in any IRA, the distribution you take from any IRA will include a prorated amount of that after-tax money," explains Jeffrey Levine, chief planning officer of Buckingham Wealth, who has written extensively on this topic.

Levine gives the example of a client with $1 million in combined traditional IRA and SEP/SIMPLE IRAs, of which $50,000 is after-tax, or 5% of the total balance. That would translate to 5% of any distribution from either IRA being non-taxable and the remaining 95% taxable.

"So if we imagine [the client] took a $30,000 distribution from somewhere in that example, $1,500 of that, or 5%, will be tax free. The other $28,500 or 95%, would be taxable to the individual."

The main reason to make nondeductible contributions to IRAs is to make Roth conversions, he says. But clients trip up on the idea they can simply convert that amount to a Roth IRA.

"They put in a $7,000 nondeductible contribution [to a traditional IRA], oftentimes doing it in a new IRA thinking, 'oh, I'm gonna convert that $7,000 [to a Roth].' Like they specifically identify it. And the reality is they can't because they get trapped with this pro rata rule."

The problem is already having pretax funds in a traditional IRA, he says. Those who don't already have a pretax IRA can contribute after-tax funds and then convert them to a Roth without a pro rata rule event.

"For argument's sake, [401(k)] plans and IRA money are treated differently," he says. "If you've got a big plan balance, but you have no IRA money, you can make that nondeductible IRA contribution without fear of the pro rata rule, because your [401(k)] plan balance doesn't count."

QCDs and Rollovers

He adds that there are key exceptions to the pro rata rule.

One is qualified charitable distributions, or QCDs, which can only be taken from pretax dollars.

"It's a way to kind of burn down your pre-tax money," he says.

The second is rollovers to employer plans with pre-tax dollars. In this case, Levine notes, the pre-tax money is sort of "vacuumed" out of the IRA, leaving only the after-tax money or zeroing out the IRA.

Levine explains how this would work using the previous example of an account with $1 million.

"If someone wants to do backdoor Roth contributions, move the $1 million in their IRA into an employer plan [assuming that is allowed], leave it there and then have a $0 IRA balance. And now they can make those backdoor Roth IRA contributions [without pro rata implications]."

The caveat here is timing. In this example, if someone has done a backdoor Roth, then retired and rolled plan money into a traditional IRA within the same calendar year, the pro rata rule would kick in, he says.

Levine adds that a backdoor Roth isn't the only solution for some high-income clients.

"Roth 401(k)s, or plan Roth contributions, don't have any income limits, like Roth IRA contributions do," Levine says. "So if someone has already maximized their Roth 401(k), then they may look for additional places to put the next dollars. But if that [bucket] hasn't yet filled up, that may just be an easier solution."