Continuing the discussion of IRA distributions, it is important to understand the Pro-Rata rule – which comes into play when you have both deductible and after-tax contributions in your Traditional IRA account. As you take distributions from the account, each distribution is treated as partly taxable and partly non-taxable, in proportion of the after-tax contributions related to the overall account balance.
So How Does The Pro-Rata Rule Work?
For an example, let’s say you have a Traditional IRA (TIRA) with a balance of $100,000. Over the years you made both deductible and after-tax contributions to this account… and your after-tax contributions amount to $25,000. It’s not necessary to know the amount of the deductible contributions (for this exercise), just the after-tax contributions.
For this tax year, you’ve chosen to take distribution of $10,000 from your TIRA. When you prepare your tax return next year, you’ll include $7,500 in ordinary income, excluding the $2,500 which is the proportionate amount of your distribution representing your after-tax contributions. In this example, one dollar out of every four is considered return of your after-tax contributions.
That’s pretty simple, right? So why is this deemed worthy of a whole blog post? Hold your horses, I’m about to tell you…
Why This Is Worthy Of A Whole Blog Post
This is especially important when planning your Roth IRA conversions – which may be a significant activity for many in 2010. When you do the conversion, this is essentially a distribution from your TIRA, and as such you are liable for ordinary income tax on the taxable portion of your distribution.
This is one of the reasons that financial advisors often recommend that, if you’re going to make non-deductible contributions to a TIRA with the intent to convert the account to a RIRA, that you make them in a completely seperate account. This way, the only portion that would be taxable at the distribution (conversion) would the be the growth of the funds, such as capital appreciation and dividends.
But I didn’t pay attention…!
Now, if you’ve thrown caution to the wind and made both deductible and after-tax contributions to the same account, or if your account has grown significantly, there is still a way to convert only the after-tax amounts to a Roth IRA, but there are some restrictions as well.
If you have access to a 401(k) plan or other employer-sponsored retirement plan (other than an IRA) that will accept rollover amounts (you’ll have to check this with your plan sponsor, some do not accept rollovers), you are allowed to rollover the amount from your IRA that represents everything but your after-tax contributions. If you can pull this off, then you can convert the remainder amounts to your Roth IRA without a taxable event. Pretty cool, huh?
All of these transactions can carry significant tax penalties if you make a mistake, so you need to be doubly sure that you’re doing it right before you make a move. There are no “do overs” for these transactions (well, not without jumping through hoops or other places that you don’t want to consider). Consult your tax advisor to make sure you’re doing it correctly if you’re not sure.
Photo by GrahamAndDairne
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I can learn from you, you can learn from me - please leave your comments and links!Jim Blankenship, CFP®, EA, is an expert in personal retirement, IRAs, and tax issues, with more than 25 years of experience in the industry. Read more from this author
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