Pro rata rule on Roth IRA conversions: What to know & how to avoid

If you have your eye on a Roth IRA or backdoor Roth IRA conversion to help boost your pool of tax-free retirement income, there's a regulation to put on your radar.

The IRS's pro rata rule can complicate Roth IRA conversions and ring up an unnecessary tax bill, if you're not careful. To help streamline your Roth conversions and minimize your tax burden, you'll want to get a strong understanding of how the pro rata rule for backdoor Roth works, when it applies, and tips to help maximize a Roth conversion while reducing your tax burden.

When you do a Roth IRA conversion, you move assets from a pre-tax retirement account (like a traditional, SEP or SIMPLE IRA, or a 401[k]) into a Roth IRA. You pay taxes on the Roth conversion amount the next time you file taxes. Suppose you want to convert $20,000 in a traditional IRA to a Roth IRA. If you're in the 24% tax bracket, you'd need to come up with $4,800 to cover the taxes on the conversion when you file next (and money from that conversion can't be used to pay the tax bill without potentially incurring additional taxes and other costs).

This type of conversion can be an especially attractive option for:

• People who expect to be in a higher tax bracket in retirement and may want tax savings on future retirement withdrawals.
• Savers who'd like to avoid RMDs.
• Earners who make too much to contribute to a Roth IRA. (In this case, you may consider a backdoor Roth IRA strategy, where you contribute to a traditional IRA with after-tax dollars and then convert it to a Roth IRA.)

Sound simple? That's where the pro rata rule may add some complexities.

The pro rata rule is a requirement by the IRS that prevents taxpayers from selectively converting only the after-tax portion of their IRA to a Roth IRA. Instead, it's taxed in proportion to your pre-tax and after-tax contribution percentages.

If you've only made pre-tax contributions to a traditional IRA, the pro rata rule won't apply to your Roth conversion. You'll simply pay ordinary income taxes on the converted amount. But if you have accounts with a combination of pre- and after-tax contributions, the pro rata rule applies.

The best way to understand how to calculate the pro rata rule is to see it in action.

Say you have a $200,000 traditional IRA with $150,000 in deductible (pre-tax) contributions and total earnings in the account and $50,000 in non-deductible (post-tax) contributions. Since you've already paid taxes on the $50,000, you might think that you could convert up to $50,000 of the account to a Roth and you wouldn't have to pay any taxes.

However, that isn't the case.

In this instance, 75% of your traditional IRA is pre-tax money and 25% is post-tax. When you convert to a Roth, the IRS will assess taxes on 75% of the converted amount. The pro rata rule also says you can't pick and choose which funds to convert. If you try to convert only $50,000 (the post-tax portion), the IRS will still say that 75% of that amount is taxable.

One final note: The pro rata rule applies in aggregate. This means that if you have multiple IRAs, the IRS treats them as one when determining the percentage of pre- and post-tax contributions and the ultimate taxable amount of any conversion.

To avoid the pro rata rule—or at least, minimize its impacts—you have multiple financial and tax strategies at the ready.

• Stick with one type of contribution. By limiting IRA contributions to strictly after-tax, you can lessen the impact of the pro rata rule should you choose to do a Roth conversion. For example, if you make after-tax contributions and those contributions generate any earnings in the account, you still have a pro rata problem since earnings are pre-tax.
• Use multiple conversions to lessen the tax burden. High-dollar Roth conversions could lead to significantly higher tax bills. A financial advisor can help you leverage multiple conversions over multiple tax years to make the required tax payments more manageable.
• Use charitable giving to reduce tax implications. You can avoid the pro rata rule if you use your pre-tax contributions to make qualified charitable contributions. Under the rule, pre-tax money and its earnings are distributed first. Funds remaining in your IRA will be after-tax, making a Roth conversion less tricky.
• Roll pre-tax contributions into your employer's 401(k). If your employer's plan allows, rolling your IRA's pre-tax contributions over to its 401(k) leaves only after-tax contributions in your traditional IRA—and Roth conversions are more straightforward.

To get the most benefit from a Roth IRA conversion, it's important to know how the pro rata rule could impact your tax obligations. If you have traditional IRAs with a combination of pre- and after-tax contributions, it could be helpful to speak with a Thrivent financial advisor near you. Together, you can chart a course that simplifies your conversions and offers the financial confidence you deserve when it comes to planning your future.