The Pro-Rata Rule: The Hidden Tax Trap Blocking Your Backdoor Roth
The Pro-Rata Rule: The Hidden Tax Trap Blocking Your Backdoor Roth
COACHING POINTS
- The Strategy: High earners (>$230k MFJ) cannot contribute directly to a Roth IRA. Instead, they use the Backdoor Roth: Contribute to a Traditional IRA (non-deductible), then immediately convert it to Roth.
- The Trap: If you have any other Pre-Tax IRAs (Rollover IRA, SEP IRA, SIMPLE IRA), you cannot just convert your new $7,000 contribution. The IRS applies the Pro-Rata Rule, forcing you to pay taxes on a portion of the conversion based on your total IRA balance.
- The Solution: You must “hide” your pre-tax IRA money by moving it into a 401(k) (Reverse Rollover) before December 31st, leaving only the non-deductible cash in the IRA for conversion.
The IRS views all your Traditional IRAs as one single bucket. You cannot cherry-pick the “after-tax” dollars to convert while leaving the “pre-tax” dollars behind. Think of it like cream in coffee. Once you pour the cream (after-tax money) into the coffee (pre-tax IRA), you cannot spoon the cream back out. Every spoonful you take (conversion) will be mostly coffee (taxable). Source: IRS Form 8606 Instructions (Line 6)
Scenario: You have an old Rollover IRA with $93,000 (Pre-Tax). You want to do a $7,000 Backdoor Roth.
- Step 1: You contribute $7,000 (Non-Deductible) to a new Traditional IRA.
- The Aggregation: The IRS sees Total IRA Balance = $93,000 (Old) + $7,000 (New) = $100,000.
- The Ratio: Only $7,000 is tax-free. ($7,000 / $100,000 = 7%).
- The Conversion: You convert $7,000 to Roth.
Tax-Free Portion: 7% ($490).
Taxable Portion: 93% ($6,510). - Result: Instead of a tax-free maneuver, you just added $6,510 to your taxable income. The trap is sprung.
What-If Scenario: The “Reverse Rollover” Fix
Comparison: Executing Backdoor Roth with vs. without clearing the path.
| Action | IRA Balance on Dec 31 | Tax on Conversion |
|---|---|---|
| Ignore Rule | $93,000 (Pre-Tax) | High (Pro-Rata applies) |
| Reverse Rollover | $0 (Moved to 401k) | $0 (Pure conversion) |
Visualizing the Tax Hit
| Strategy | Taxable Income Generated ($) |
|---|---|
| Clean Backdoor (No other IRAs) | 0 |
| Pro-Rata Triggered ($93k IRA) | 6510 |
*Failing to empty your pre-tax IRA accounts before converting turns a tax-neutral event into a taxable one.
Which Accounts Trigger Pro-Rata?
| Account Type | Triggers Rule? (1=Yes, 0=No) |
|---|---|
| Traditional / Rollover IRA | 1 |
| SEP / SIMPLE IRA | 1 |
| 401(k) / 403(b) | 0 |
| Spouse’s IRA | 0 |
| Inherited IRA | 0 |
*Crucially, 401(k)s and your spouse’s IRAs are ignored. The rule aggregates only YOUR non-Roth IRAs.
Execution Protocol
Do you have a Rollover IRA from an old job? Do you have a SEP IRA from side income? If the balance of these accounts is >$0 on December 31 of the conversion year, you have a problem.
Contact your current 401(k) administrator. Ask if they accept “incoming rollovers” from IRAs. If yes, move your entire pre-tax IRA balance into the 401(k). This effectively “hides” the money from the Pro-Rata calculation.
Once the pre-tax IRA balance is $0, contribute your $7,000 (non-deductible) to the empty IRA and convert it to Roth. File Form 8606 with your tax return to prove the conversion was non-taxable.
COACHING DIRECTIVE
- Do This: Clear your pre-tax IRA decks before attempting a Backdoor Roth. If you can’t move the money to a 401(k), consider simply converting it all to Roth and paying the tax (if the balance is small, e.g., <$5k).
- Avoid This: forgetting about a small SEP IRA or SIMPLE IRA. Even a $1 balance triggers the calculation form (Form 8606) and complicates your tax filing.
Frequently Asked Questions
Does my spouse’s IRA affect me?
No. IRAs are “Individual.” Your spouse’s pre-tax IRA balances do not affect your Pro-Rata calculation, and vice versa. You file separate Form 8606s even if filing taxes jointly.
What if I do the conversion in January?
The IRS looks at your IRA balance on December 31st of the year the conversion happened. Even if the account was empty in January, if you roll money into an IRA in November, you retroactively trigger the rule for the whole year.
Does an Inherited IRA count?
No. Beneficiary (Inherited) IRAs are excluded from the aggregation rule. They do not trigger Pro-Rata.