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Avoiding Pre-Retirement Rollover Traps: The Pro Rata Rule

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As a client approaches retirement age, he or she may consider making several last minute retirement income planning moves in order to maximize asset value and streamline plan administration. 

Two of the most popular moves are Roth conversions and employer-sponsored 401(k)-to-IRA rollovers—but unfortunately, these are two retirement income planning strategies that often do not mix. While it’s true that an IRA-to-Roth conversion will create tax-free income during retirement and rolling 401(k) funds into an IRA can serve to streamline retirement income administration, if caution is not exercised when combining these two strategies, the result will be one that no client approaching retirement will appreciate—a big tax bill.

The Complications of a High-Income Client’s Roth Conversion

Many of your clients will be subject to income limitations for deducting IRA contributions. In 2015, a single person who participates in another employer-sponsored plan cannot deduct IRA contributions if his or her income exceeds $71,000 (the threshold is $118,000 for married individuals if the contributing spouse is covered by a workplace plan, or $193,000 if the spouse who makes the contribution is not covered, but is married to someone who is).

However, clients may make nondeductible contributions to an IRA when adjusted gross income is too high to qualify for a tax deduction. Nondeductible IRA funds are contributed into the same type of account as traditional contributions.

Roth accounts have similar income limitations—a single taxpayer cannot contribute to a Roth IRA directly if he or she has adjusted gross income that exceeds $131,000 in 2015 ($193,000 for married taxpayers filing jointly). This eliminates the Roth contribution strategy for higher-income clients—unless the client first makes nondeductible contributions to an IRA and converts those funds to a Roth.

If all of the client’s IRA contributions were nondeductible when made because of the income restrictions discussed above, the client can convert the IRA funds to a Roth account—thus reducing required minimum distributions (RMDs) and generating tax-free income later in retirement—without tax liability.

Adding a 401(k) Rollover into the Mix

If, however, the client also wishes to roll over his or her employer-sponsored 401(k) into a traditional IRA prior to retirement, the client’s tax bill for the Roth conversion can increase dramatically.  Generally, the 401(k)-to-IRA rollover would not generate any tax consequences if properly executed.  Unfortunately, completing a Roth conversion in the same year will generate unfavorable tax results if the client has nondeductible IRA contributions because of a rule known as the “pro rata rule.”

The pro rata rule requires that a taxpayer include all IRA assets when determining the taxes due on a Roth conversion.  For example, if the client has $20,000 worth of nondeductible IRA assets and converts the entire $20,000 to a Roth, he or she will owe no tax on the conversion because no portion of the converted assets represent pre-tax (deductible) contributions. 

However, if the client had $80,000 in a 401(k) and rolls these assets into his or her $20,000 IRA, and converts $20,000 to a Roth within the same year, the entire $100,000 IRA balance must be used in determining the portion of the conversion that is taxable—meaning that only 20% of the conversion will be nontaxable ($20,000 is 20% of the entire $100,000 balance).

As a result, by implementing both strategies within the same year, a completely nontaxable transaction can be turned into a transaction that is 80% taxable—a result that could be avoided if the transactions took place in separate tax years.


While both a Roth conversion and 401(k)-to-IRA rollover can be beneficial to a client’s overall retirement income strategy, implementing both within a single tax year can have undesirable tax consequences—even if a client is fast approaching retirement age.

Originally published on Tax Facts Onlinethe premier resource providing practical, actionable and affordable coverage of the taxation of insurance, employee benefits, small business and individuals.    

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