Announcement

Collapse
No announcement yet.

Help me understand the pro-rata rule implications for a backdoor Roth IRA

Collapse
X
 
  • Filter
  • Time
  • Show
Clear All
new posts

  • Help me understand the pro-rata rule implications for a backdoor Roth IRA

    Sorry if this has been asked before. I currently have an old IRA from an old employer, and a SEP IRA. I'm trying to figure out whether, if I roll both IRAs into my solo 401(k) this year, I can do a backdoor Roth contribution and conversion this year without incurring additional tax obligations.

    I'm reading articles about backdoor Roth conversions, and I don't understand this pro-rata rule. For example, take this article from Forbes, which says:

    For example, let’s say you have $94,000 in existing traditional IRAs that were funded with pre-tax dollars. And now you contribute $6,000 to a new traditional IRA with after-tax dollars, then immediately convert that $6,000 to a Roth via the backdoor Roth IRA strategy.

    As far as the IRS is concerned, you now have $100,000 in traditional IRAs, and the $6,000 you are contributing with after-tax dollars represents 6% of your total. That means only $360 of your $6,000 backdoor conversion is tax-free (6% of $6,000). You owe income tax on the other $5,640 you backdoored.
    Maybe I'm just getting dumber as I get older, but I don't understand why any of my conversion would be tax-free in the first place. That's the point of a Roth IRA--the contributions are taxed, but the withdrawals are not--isn't it? I'm making a $6000 non-deductible contribution, meaning that's post-tax money. Of course I owe income tax on it.

    If I didn't already have $94,000 in an IRA, if I didn't already have an IRA at all, that $6000 would be pre-tax money, and I could convert it to a Roth IRA so that the eventual withdrawals after I'm 59 1/2 would be tax-free as well? Is that what this article is saying? That can't be right. What am I missing?


  • #2
    [/QUOTE] That's the point of a Roth IRA--the contributions are taxed, but the withdrawals are not--isn't it? [/QUOTE]

    Correct.

    [/QUOTE]
    If I didn't already have $94,000 in an IRA, if I didn't already have an IRA at all, that $6000 would be pre-tax money, and I could convert it to a Roth IRA so that the eventual withdrawals after I'm 59 1/2 would be tax-free as well?
    [/QUOTE]

    Correct.

    [/QUOTE]
    Is that what this article is saying? That can't be right. What am I missing?

    [/QUOTE]

    Incorrect. The article is highlighting the pro rata rule. The pro rata rule prohibits you from ONLY converting that $6k with basis you've already paid tax on. So if you have IRA money without basis and attempt to do the backdoor, you will owe taxes because you'll be converting a portion of your IRA money without basis.

    Comment


    • #3
      Originally posted by Arcite View Post
      Sorry if this has been asked before. I currently have an old IRA from an old employer, and a SEP IRA. I'm trying to figure out whether, if I roll both IRAs into my solo 401(k) this year, I can do a backdoor Roth contribution and conversion this year without incurring additional tax obligations.

      I'm reading articles about backdoor Roth conversions, and I don't understand this pro-rata rule. For example, take this article from Forbes, which says:



      Maybe I'm just getting dumber as I get older, but I don't understand why any of my conversion would be tax-free in the first place. That's the point of a Roth IRA--the contributions are taxed, but the withdrawals are not--isn't it? I'm making a $6000 non-deductible contribution, meaning that's post-tax money. Of course I owe income tax on it.

      If I didn't already have $94,000 in an IRA, if I didn't already have an IRA at all, that $6000 would be pre-tax money, and I could convert it to a Roth IRA so that the eventual withdrawals after I'm 59 1/2 would be tax-free as well? Is that what this article is saying? That can't be right. What am I missing?
      What you are missing is that you have ALREADY paid the taxes due on the $6,000 contribution, but NOT on the $94,000 already in the IRA (as you previously claimed those contributions as tax deductions; they lowered you annual Adjusted Gross Income). The pro-rata rule works by claiming all the money in the IRA is completely and irrevocably mixed together (like mixing together two colors of paint); just as you can't just withdraw the white paint from the bucket and leave the black paint behind, you can't just convert the already-taxed part of the IRA and leaved the untaxed part behind. So when you carry out the conversion you don't owe taxes on the percentage that comes from the already-taxed money, but DO owe taxes on the percentage you claimed as a tax deduction (and on any gains those contributions may have made over time). On an IRA that has $100,000 in it, with $94,000 being untaxed and $6,000 post tax, that means that you will owe taxes on 94% of the money you convert, but no taxes on 6% of that money. So you will owe taxes on $5,640 of the $6,000 conversion.

      When there is no money in the IRA and the contribution to the IRA was NOT claimed as a tax deduction, you owe no taxes on the Roth conversion because you have already paid them on the money you contributed to the IRA (so long as you do the conversion before any gains, which would be taxable, are made). That's a clean Backdoor Roth conversion. And once the money is in the Roth IRA, withdrawals follow the rules for Roth accounts, o you will owe no taxes on withdrawals (including any gains made) made after age 59 1/2.
      Last edited by artemis; 11-17-2021, 07:26 PM. Reason: Corrected to fix some math errors (percent taxable is 94%, not 96%)

      Comment


      • #4
        As long as you roll both the pre-tax IRA and the SEP (also a pre-tax IRA) to your 401k before 12/31/21, you will owe no prorata tax for making a backdoor Roth conversion in 2021 - even if you convert before you roll the IRAs to your 401k.

        Check with your HR dept, your FA, or read your ADV to make sure your 401k accepts rollovers (most do).

        The only day of the year that counts for the prorata calculation is 12/31 of the year you convert.

        Welcome to the forum!
        Our passion is protecting clients and others from predatory and ignorant advisors. Fox & Co CPAs, Fox & Co Wealth Mgmt. 270-247-6087

        Comment


        • #5
          Originally posted by artemis View Post

          What you are missing is that you have ALREADY paid the taxes due on the $6,000 contribution, but NOT on the $94,000 already in the IRA (as you previously claimed those contributions as tax deductions; they lowered you annual Adjusted Gross Income). The pro-rata rule works by claiming all the money in the IRA is completely and irrevocably mixed together (like mixing together two colors of paint); just as you can't just withdraw the white paint from the bucket and leave the black paint behind, you can't just convert the already-taxed part of the IRA and leaved the untaxed part behind. So when you carry out the conversion you don't owe taxes on the percentage that comes from the already-taxed money, but DO owe taxes on the percentage you claimed as a tax deduction (and on any gains those contributions may have made over time). On an IRA that has $100,000 in it, with $96,000 being untaxed and $6,000 post tax, that means that you will owe taxes on 96% of the money you convert, but no taxes on 4% of that money. So you will owe taxes on $5,760 of the $6,000 conversion.

          When there is no money in the IRA and the contribution to the IRA was NOT claimed as a tax deduction, you owe no taxes on the Roth conversion because you have already paid them on the money you contributed to the IRA (so long as you do the conversion before any gains, which would be taxable, are made). That's a clean Backdoor Roth conversion. And once the money is in the Roth IRA, withdrawals follow the rules for Roth accounts, o you will owe no taxes on withdrawals (including any gains made) made after age 59 1/2.
          Wait, so if you do this "wrong," the money is taxed twice? Maybe that's the source of my confusion. None of the articles I've found make this clear. Let me see if I have this straight: in the above scenario, the $6,000 contribution is post-tax money, it's a non-deductible contribution, but then when I roll it over into the Roth, the conversion triggers another round of taxes on $5,760 of it? Whereas if I'd gotten rid of the traditional IRA first, I'd pay taxes on the $6,000 in the course of that money being part of my regular taxable income for the year, but there would be no tax on the conversion? Do I have that right?

          Comment


          • #6
            Originally posted by Arcite View Post

            Wait, so if you do this "wrong," the money is taxed twice? Maybe that's the source of my confusion. None of the articles I've found make this clear. Let me see if I have this straight: in the above scenario, the $6,000 contribution is post-tax money, it's a non-deductible contribution, but then when I roll it over into the Roth, the conversion triggers another round of taxes on $5,760 of it? Whereas if I'd gotten rid of the traditional IRA first, I'd pay taxes on the $6,000 in the course of that money being part of my regular taxable income for the year, but there would be no tax on the conversion? Do I have that right?
            no. it’s that you’re only able to convert a pro rata (proportional) amount of the after tax dollars. the tax being paid is bc you’re converting $5760 of pretax dollars

            Comment


            • #7
              Originally posted by Arcite View Post
              in the above scenario, the $6,000 contribution is post-tax money, it's a non-deductible contribution, but then when I roll it over into the Roth, the conversion triggers another round of taxes on $5,760 of it?
              No, the $6,000 is a mix of pre-tax and post-tax money. That is the whole point of the pro rata rule: you CANNOT keep the pre-tax and post-tax dollars in the IRA separate (any more than you can keep black and white paint separate if you put them into a single bucket, it all blends to become gray). 94% of the total sum in the IRA is pre-tax after you add the $6,000 after-tax contribution to the $94,000 already in the IRA from pretax contributions + taxable gains; therefore you have to pay tax on 94% percent of the conversion.

              (I edited the earlier post to correct a couple of math errors. It's been a long day.)

              And as jfoxcpacfp has already said, the way out of the problem is to pour ALL of the white paint out of the bucket before you add any black paint - in other words, roll your current IRA and SEP IRA moneys into your solo 401k. THEN you can make the after-tax $6,000 IRA contribution and convert it to a Roth IRA without owing any taxes. But hurry! You may not be able to do the Backdoor Roth trick after December 31, so get started on those IRA/SEP IRA rollovers NOW!!! They have to be completed before 12/31, or the pro rata rule will kick in.
              Last edited by artemis; 11-17-2021, 07:52 PM.

              Comment


              • #8
                Originally posted by artemis View Post

                No, the $6,000 is a mix of pre-tax and post-tax money. That is the whole point of the pro rata rule: you CANNOT keep the pre-tax and post-tax dollars in the IRA separate (any more than you can keep black and white paint separate if you put them into a single bucket, it all blends to become gray). 94% of the total sum in the IRA is pre-tax after you add the $6,000 after-tax contribution to the $94,000 already in the IRA from pretax contributions + taxable gains; therefore you have to pay tax on 94% percent of the conversion.

                (I edited the earlier post to correct a couple of math errors. It's been a long day.)

                And as jfoxcpacfp has already said, the way out of the problem is to pour ALL of the white paint out of the bucket before you add any black paint - in other words, roll your current IRA and SEP IRA moneys into your solo 401k. THEN you can make the after-tax $6,000 IRA contribution and convert it to a Roth IRA without owing any taxes. But hurry! You may not be able to do the Backdoor Roth trick after December 31, so get started on those IRA/SEP IRA rollovers NOW!!! They have to be completed before 12/31, or the pro rata rule will kick in.
                I still don't understand. You say I can make the after-tax $6,000 IRA contribution and convert it to a Roth IRA without owing any taxes. That doesn't make sense. I pay taxes on the $6,000, right? That's after-tax money. So what problem am I avoiding by getting rid of the traditional IRA first? I'd rather pay taxes on $5,760 than on $6,000.

                I have a feeling there is something fundamental here I'm not grasping.

                Comment


                • #9
                  A small clarification. The order/timing of any contributions, rollovers and Roth conversions does not matter for prorata taxation.

                  Prorata taxation only occurs when you; carryover or contribute non-deductible basis, have any pre-tax balances in all traditional, SEP or SIMPLE IRA accounts on 12/31 of a year you do one or more Roth conversions.

                  However with that said. You should complete and verify that any rollovers have been successfully completed, before doing any Roth conversions. The SECURE ACT eliminated the ability to do recharacterizations of Roth conversions.

                  Comment


                  • #10
                    Originally posted by Arcite View Post
                    I still don't understand. You say I can make the after-tax $6,000 IRA contribution and convert it to a Roth IRA without owing any taxes. That doesn't make sense. I pay taxes on the $6,000, right? That's after-tax money. So what problem am I avoiding by getting rid of the traditional IRA first? I'd rather pay taxes on $5,760 than on $6,000.

                    I have a feeling there is something fundamental here I'm not grasping.
                    You already paid taxes on the $6k. That’s why it is referred to as “after tax.” What you are missing is that the pro rata rule will make a portion (94/100) of your $6k after tax contribution to the IRA taxable AGAIN at the point of conversion to Roth from the IRA because of how the rules are written. The way to avoid the pro rata rule in your example is to empty the IRA of the pre-tax $94k by rolling it over to another tax deferred account like a 401k. Then when you convert the $6k to Roth there is no longer any pre tax money in the IRA to dilute it. The conversion of the $6k in essence becomes a non taxable event.

                    Maybe this will help. Forget the Forbes example. Read this tutorial and see if it helps clarify the rules. https://www.whitecoatinvestor.com/ba...-ira-tutorial/

                    Comment


                    • #11
                      Originally posted by Larry Ragman View Post

                      You already paid taxes on the $6k. That’s why it is referred to as “after tax.” What you are missing is that the pro rata rule will make a portion (94/100) of your $6k after tax contribution to the IRA taxable AGAIN at the point of conversion to Roth from the IRA because of how the rules are written. The way to avoid the pro rata rule in your example is to empty the IRA of the pre-tax $94k by rolling it over to another tax deferred account like a 401k. Then when you convert the $6k to Roth there is no longer any pre tax money in the IRA to dilute it. The conversion of the $6k in essence becomes a non taxable event.

                      Maybe this will help. Forget the Forbes example. Read this tutorial and see if it helps clarify the rules. https://www.whitecoatinvestor.com/ba...-ira-tutorial/
                      not correct. the after tax dollars are not taxed again

                      the $94 being taxed are pretax dollars

                      Comment


                      • #12
                        Originally posted by Arcite View Post
                        I still don't understand. You say I can make the after-tax $6,000 IRA contribution and convert it to a Roth IRA without owing any taxes. That doesn't make sense. I pay taxes on the $6,000, right? That's after-tax money. So what problem am I avoiding by getting rid of the traditional IRA first? I'd rather pay taxes on $5,760 than on $6,000.

                        I have a feeling there is something fundamental here I'm not grasping.
                        What you don’t seem to be grasping is that you have NOT paid any taxes on your previous contributions (they gave you a tax break), or on the investment gains they made. THAT is what is triggering the taxation. On 12/31 the paint mixer is turned on and all the money gets mixed together. But if you move that taxable money into your solo 401k (which has the same withdrawal rules as an IRA - contributions give you a tax break, but withdrawals are taxed) by 12/31, your $6,000 nondeductible contribution (which you have already paid taxes on) can be rolled into a Roth IRA without triggering a tax event.

                        I also think you are hazy on the difference between traditional and SEP IRAs and Roth IRAs.

                        Anyone can make a contribution to an IRA, but your income has to be below a certain level in order to claim that contribution as a tax deduction. If your income is below that limit, making an IRA contribution lowers your taxable income. During the years the money stays in the IRA it grows tax-free. But after age 59 1/2, withdrawals are taxed at ordinary income rates (not at the lower capital gains rate).

                        There is a hard income limit for making a direct contribution to a Roth IRA. If you are below that income level, you can contribute directly to a Roth IRA, but you pay income taxes on that contribution. That $6000 contribution is after tax money. Once the money is in the Roth IRA it grows tax-free. After age 59 1/2, all the withdrawals are tax free as well.

                        So for ordinary people the benefit of contributing to an IRA comes upfront, while the benefit of contributing to a Roth IRA comes at the back end. Hence the common advice to contribute to a Roth IRA early in one’s career when your income is at its lowest and your tax bracket is low (so an up-front tax break isn’t as valuable) and then switching to contributing to an IRA when one’s salary had increased and one’s tax bracket has gone up.The up-front tax break of a deductible IRA contribution is more valuable at higher levels of taxation.

                        But what about for high income earners like physicians? We can’t contribute directly to a Roth IRA at all. And we cannot deduct our contribution to a traditional IRA on our taxes. So we contribute $6000 of after-tax money to our IRA and then we pay taxes after age 59 1/2 when we start making withdrawals . The only benefit we get is the tax free growth in the middle. Compared to the benefits offered to lower income people, that sucks! We are paying taxes at both ends!

                        But about 10 years ago Congress changed the rules on Roth conversions. They kept the hard limit for making a direct contribution to a Roth IRA, but they allowed people of any income level to do Roth conversions. That means that by making a taxable contribution to an IRA and then immediately converting it to a Roth IRA before that money makes any taxable gains, we’ve done the equivalent in two steps of what lower income people can do in one step by making a direct Roth IRA contribution. Now we’re only paying tax at the front end, we’re not paying tax down the road on the withdrawals. That is the point of the backdoor Roth. Better to pay tax at only one end then at both ends. But in order to use that trick, there needs to be NO pretax money in the IRA on 12/31 when the paint mixer is turned on.

                        Does that clear things up?

                        Comment


                        • #13
                          And here’s an example that might help clarify things. (Let’s pretend for this example you only have an IRA instead of an IRA and a SEP IRA, as it simplifies things a bit.)

                          Suppose in September 2021 you did a $6000 conversion from your IRA to a Roth IRA. Your IRA had a total amount of $94,000 in it at the time you made the conversion, and all $94,000 was from pre-tax contributions from prior years and investment gains.

                          In October 2021 you make a nondeductible $6000 IRA contribution.

                          In November 2021 you move all of the money left in your IRA into your solo 401(k).

                          December 31 arrives. If you did things correctly, there is no money left in your IRA. Because you moved all that money to your 401(k) prior to December 31, the pro rata rule does not apply. But if there is even a dime of taxable money left in that account, the pro rata rule will kick in.

                          The IRS is treating money as fungible. It doesn’t care which particular dollars you moved to the Roth IRA or exactly when you did it. It only cares that on 12/31 no investment gains or pre-tax money is present in your IRA. Having any taxable money in those two accounts is what would trigger the pro rata rule, and you’d owe taxes on the Roth conversion.
                          Last edited by artemis; 11-18-2021, 06:31 AM.

                          Comment


                          • #14
                            Originally posted by Larry Ragman View Post

                            You already paid taxes on the $6k. That’s why it is referred to as “after tax.” What you are missing is that the pro rata rule will make a portion (94/100) of your $6k after tax contribution to the IRA taxable AGAIN at the point of conversion to Roth from the IRA because of how the rules are written.
                            OK, that's the source of the confusion then. Because I asked above if, if I already have a traditional IRA with pre-tax money from years past in it and the pro-rata rule applies, my contribution is essentially taxed twice, and people told me no, that's wrong. But it's sounding like it's true.

                            The way to avoid the pro rata rule in your example is to empty the IRA of the pre-tax $94k by rolling it over to another tax deferred account like a 401k. Then when you convert the $6k to Roth there is no longer any pre tax money in the IRA to dilute it. The conversion of the $6k in essence becomes a non taxable event.
                            I understand that. What I don't understand is what is the advantage to doing it that way rather than leaving the pre-tax $94k IRA as is. I would presume the reason is that, if you get hit with the pro-rata rule, you have to pay more total taxes that year than you would if you had not gotten hit with the pro-rata rule. But the articles I'm reading are not making this clear.

                            Maybe this will help. Forget the Forbes example. Read this tutorial and see if it helps clarify the rules. https://www.whitecoatinvestor.com/ba...-ira-tutorial/
                            OK, I read that tutorial. Based on my understanding of it, if you get hit with the pro-rata rule, you do in fact pay more total taxes that year. Let me rephrase my "taxed twice" theory. The $6000 comes from money I've already paid taxes on. It started life as, say $9000, then I paid taxes. Now I have $6000. I do a backdoor Roth while having $94k in a traditional IRA from previous years. That triggers the pro-rata rule. The IRS says "we consider all your IRA money to be in one big pool. 94% of your IRA money has not been taxed yet. Therefore, we are taxing 94% of your Roth conversion." This is equal to $5640. So now I have to pay more taxes on $5640, in addition to the taxes I already paid (i.e., the taxes that turned $9000 into $6000.)

                            Is that right?

                            Comment


                            • #15
                              Originally posted by artemis View Post
                              But about 10 years ago Congress changed the rules on Roth conversions. They kept the hard limit for making a direct contribution to a Roth IRA, but they allowed people of any income level to do Roth conversions. That means that by making a taxable contribution to an IRA and then immediately converting it to a Roth IRA before that money makes any taxable gains, we’ve done the equivalent in two steps of what lower income people can do in one step by making a direct Roth IRA contribution. Now we’re only paying tax at the front end, we’re not paying tax down the road on the withdrawals. That is the point of the backdoor Roth. Better to pay tax at only one end then at both ends. But in order to use that trick, there needs to be NO pretax money in the IRA on 12/31 when the paint mixer is turned on.

                              Does that clear things up?
                              I understand everything up until this paragraph.

                              So we are paying taxes at the front end regardless. But if we already had a traditional IRA with $94k of pretax money in it from previous years, we pay more taxes than if we did not. Right?

                              Let me try it this way. Let's simplify the US tax code and say that I have a flat tax rate of 30%, and that I have a MAGI of $300k, with no other deductions or exemptions. So my annual tax bill ordinarily would be $90k. But, I also have a traditional IRA I contributed to years ago with pre-tax money. That IRA now has $94k in it. And I want to create a backdoor Roth IRA in 2021.

                              Scenario 1: I roll over my traditional IRA into my solo 401(k), so that by 12/31/21, I have $0 in a traditional IRA. I take $6000 from my checking account and deposit it into the traditional IRA, then immediately roll it over into a Roth IRA.

                              In this scenario, there are no further taxes in 2021. My tax bill for 2021 remains $90k.

                              Scenario 2: I fail to roll over my traditional IRA into my solo 401(k). I take $6000 from my checking account and deposit it into the traditional IRA, then immediately roll it over into a Roth IRA. The pro-rata rule is triggered. The IRS says "we are taxing $5640 of that conversion." Therefore I have to pay an additional tax of .3 x 5640, or $1692. My total tax bill for 2021 is $91,692.

                              I know those numbers aren't realistic, I know the tax code isn't that simple, I know there are in fact tax brackets and I have various tax deductions. But on the general principle, is the above reasoning correct?

                              Comment

                              Working...
                              X