Understanding the pro-rata rule is very important, specially when planning on doing a Roth IRA conversion and other distributions. The pro-rata rule comes into play when your traditional IRA consist of pretax and after-tax money, all at the same time. Whether the funds from your IRAs came from non-deductible IRA contributions, rollovers of after-tax funds from former employer plans all these IRAs are now counted as one IRA and as you take any distributions they will all be treated as partly taxable and partly non-taxable proportionally to the tax contributions related to the overall account balance.
When the owner of the accounts is in this particular situation where he may hold both pre-tax and after-tax dollars in his IRA accounts, the IRS will look at all of your Traditional IRAs, SEP and Simple accounts as if they were actually only one big account. The pro-rata rule is a simple formula that will help you determine how much of any distribution that you may take out from the IRAs is actually taxable and how much should not.
First, it is very important to keep in mind that you will not be able to calculate the exact pro-rata percentage until the end of the tax year. This is because the values in the IRA accounts will fluctuate throughout the year therefore the pro-rata rule calculation will only be accurate by accounting for the final values in the IRA accounts as of December 31st of the current year you are planning to make the conversion
The Calculation for Total Rollover Amount
(Total After-tax Dollars in All IRAs / Total Value of All of the IRAs) * Amount Converted
Here is a simple example, let’s say you have two IRAs; one of them is worth $15,000 non-deductible and the second one is worth $50,000 deductible and you are wanting to take a distribution of $1,000 to do a roll over. How much of this $1,000 is taxable and how much is tax free?
- First, calculate the total IRA balance from all your IRA accounts combined ($65,000).
- Second, calculate the percentage of non-deductible IRS from the total balance by using the formula (23%).
$15,000 (Total after-tax dollars) / $65,000 (Total Value in All IRAs) = 23%
- Multiply the percentage by of non-deductible amount from the previous step to the to the taxable amount of your distribution.
$1,000 (amount covered) x 23% = $230
From the $1,000 distribution, $230 will be the tax-free portion and the remaining $770 would be taxable at the ordinary rates.