For many high-income clients, IRA planning requires thinking outside of the traditional box of generally applicable contribution and distribution rules. These clients may own a mixture of retirement accounts that contain a combination of pre-tax and after-tax contributions—which will likely trigger the distribution rule known as the “pro-rata rule.” Failure to understand and consider the pro-rata rule can, of course, lead to unpleasant tax surprises down the road—especially when the client wishes to engage in rollover or Roth conversion transactions.
In many cases, ignoring the pro-rata rule can turn what would have been an entirely nontaxable transaction into a transaction that generates a substantial—and completely avoidable—tax bill.
The Pro-Rata Rule: Traditional IRAs
The pro-rata rule is important to clients who maintain a traditional IRA that contains both pre-tax and after-tax (nondeductible) contributions. Generally, a client’s IRA may contain after-tax contribution if his or her income exceeds the applicable income thresholds that prohibit certain high-income clients from making pre-tax contributions to an IRA. These clients are not, however, prohibited from making after-tax contributions to an IRA.
As a result, some clients may own IRAs that contain both pre-tax and after-tax contributions. Pre-tax contributions are taxed at the client’s ordinary income tax rate when distributed, while after-tax contributions are withdrawn tax-free.
The pro-rata rule essentially requires that the proportion of pre-tax to after-tax contributions in the entire IRA pool be considered when determining how each distribution from that account is taxed. This means that the client cannot simply choose to withdraw only after-tax contributions in a single distribution in order to avoid generating tax liability.
For example, if a client has contributed $80,000 in deductible contributions to a traditional IRA and, because his or her income was too high in subsequent years, continued to fund the account with $20,000 in nondeductible contributions, the client cannot choose to withdraw from the $20,000 pool and avoid taxation. Instead, 80% of each distribution will be taxable because 80% of the entire IRA balance consists of funds that have never been taxed.
Roth IRA Application
The pro rata rule may also impact clients who choose to convert traditional IRA or 401(k) funds to a Roth IRA. 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).
If the client had completed the conversion before combining the nondeductible and deductible contributions, the tax liability could have been reduced or eliminated. As a result, by implementing both strategies (the rollover and the conversion) 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 many taxpayers will not be impacted by the pro-rata rule, high-income clients who wish to contribute to an IRA must be aware of the pro-rata rule when taking distributions or executing Roth conversions in order to avoid the unpleasant surprise tax liability that can result.
Originally published on Tax Facts Online, the premier resource providing practical, actionable and affordable coverage of the taxation of insurance, employee benefits, small business and individuals.
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