TL;DR: Backdoor Roth IRA conversions can be powerful for high-income earners, but the pro-rata rule complicates tax efficiency.
Main points:
- Backdoor Roths allow high-income individuals to bypass income limits.
- Conversions don’t count against annual contribution limits.
- The pro-rata rule means both pre-tax and after-tax funds are converted proportionally.
- Taxes can be significant—plan carefully and consider paying them with outside funds.
- In-plan Roth conversions (e.g., Roth 401k) avoid the pro-rata rule.
- Alternatives like Roth 401k may provide tax-free growth without complex conversions.
Backdoor Roth IRA conversions are attractive for high-income individuals who want to maximize their retirement savings. However, many people overlook the pro rata rule for Roth conversions in financial planning.
If you’re building a traditional IRA or 401k plan, the Roth conversion pro-rata rule reduces efficiency. The idea behind a strategic Roth conversion is for you to get the most out of the features. This would include no taxes on withdrawals and no required minimum distributions.
What is a Roth Conversion Contribution?
Before you understand the pro-rata Roth conversion rule, you need to understand what a conversion is. Roth IRAs are only available to those below a certain income limit. If you have a high income, then you must find another way to get a Roth IRA.
The workaround for this is a backdoor Roth conversion. This Roth conversion “contribution” allows for the conversion of existing retirement assets into a Roth IRA. An example would be moving money from a traditional IRA or a 401k to a Roth IRA. This isn't like a normal contribution where you add new funds.
Does a Roth Conversion Count Against Contribution Limits?
No, Roth conversions don’t affect your contribution limits. Why not? Because you are transferring existing funds from one retirement account to another account with a different tax treatment.
Annual contribution limits only apply to new funds you contribute to a retirement account. You can still take full advantage of contribution limits when you make a conversion.
What is the Pro-Rata Rule for Roth Conversions and How Does It Work?
The pro-rata rule for Roth conversion calculates the taxable amount proportionally.
Think of it like a cake with frosting. The plain cake is your pre-tax funds, and the frosting is your after-tax funds. You can’t scrape off the frosting to only convert after-tax money. The Roth conversion pro-rata rule forces you to cut a slice of the whole cake. The pro rata rule for backdoor Roth conversions mean you convert both tax-deferred and after-tax funds together.
You always fund Roth IRAs with after-tax dollars. Most people assume converting tax-deferred money to a Roth IRA makes you pay taxes on the amount converted. This only applies if your Roth contributions came from non-deductible funds from other IRA accounts or 401k plan
When does the IRA pro-rata rule for Roth conversion apply? It takes effect when you move funds from your traditional IRA or 401k plan and convert it into a Roth IRA. Higher-income individuals typically do this because income limits prevent them from qualifying for a Roth IRA.
The workaround for this is a backdoor Roth conversion. They let you convert existing retirement assets into a Roth IRA.
If you never added after-tax money to your 401k or traditional IRA, you’ll pay regular tax rate on the full Roth IRA conversion. If your traditional IRA contributions contain deductible and non-deductible contributions, the backdoor Roth IRA conversion pro-rata rule applies.
How Do You Calculate the Pro-Rata Rule for Roth Conversions?
Wondering how to calculate pro rata on backdoor Roth conversion? The Roth conversion pro-rata rule aggregates all the money you have in your IRA when you make a conversion. To do this you, will need to know the percentage of non-taxable funds. You can make that calculation this way:
- Non-taxable percentage = Non-deductible funds / Total balance across all non-Roth IRA accounts
Once you have this information, you can determine how much after-tax funds will be converted to your backdoor Roth IRA:
- After-tax funds in Roth conversion = amount to be converted to Roth IRA × non-taxable percentage
Calculating the pro rata on a backdoor Roth conversion is just a matter of following those steps.
What Challenges Can You Face with the Pro-Rata Rule for Roth Conversions?
With a large conversion of funds to a Roth account, there would be a substantial amount of taxes you need to pay upfront. Be mindful of the taxes you may owe. Having such a hefty tax bill might not be in your best interest.
Always make sure you have the proper financial plans in place to make use of and benefit from a Roth IRA. If you aren’t sure if a backdoor conversion is right for you, consult with a financial advisor on the Roth conversion pro-rata rule.
What Is a Roth In-Plan Conversion After-tax Contributions?
An "in-plan Roth conversion" occurs within an employer-sponsored plan like a 401k. Here, you convert funds from a pre-tax or after-tax account to a Roth account within the same plan. You can convert after-tax contributions into a Roth 401k or Roth 403b without paying more taxes on the principal. The backdoor Roth IRA pro-rata rule doesn’t apply here.
Earnings on these after-tax contributions are still subject to income tax at the time of conversion. Once converted, these funds, taxed earnings will grow tax-free. Withdrawals will also be tax-free under specific conditions, such as:
- the account being at least five years old
- withdrawals made after age 59½
What Is the Best Way to Pay the Taxes on a Roth Conversion?
The best way to pay taxes on a Roth conversion is with money from outside the retirement account. Funds from savings or a taxable account continues to grow tax free in your Roth account.
If you use funds from the IRA or 401k itself to cover the tax bill, you reduce the amount that gets converted. You may also face penalties if you are under age 59½.
You can:
- Convert in smaller amounts over several years to stay in a lower tax bracket.
- Use taxable investment gains or bonus income to cover the tax bill.
- Time your conversion for years when your income and tax rate are lower.
Is the Backdoor Roth IRA Pro-Rata Rule Worth It?
The backdoor Roth IRA pro-rata rule complicates retirement planning for many high-income earners. Still, with the right guidance, it can help you secure tax-free retirement growth.
If you’re unsure if the IRA pro-rata rule limits your tax advantages, seek expert advice.
What Are Alternatives to a Backdoor Roth IRA for Tax-Free Growth?
The Roth conversion pro-rata rule is discouraging if you want the benefits of tax-free growth but don’t qualify for a Roth IRA. However, some employers can give you access to plans like a Roth 401k.
A Roth 401k is like a traditional 401k in that both are employer-sponsored, but the difference is the tax treatment. The contributions you make to Roth 401k use after-tax dollars, much like with a Roth IRA. As a high-income individual, you can use this as a strong alternative to creating a backdoor Roth IRA.
However, each type of retirement plan has its advantages and drawbacks. A Roth 401k still has required minimum distributions which you must take to avoid penalties. A Roth 401k offers employer-matching contributions, and beneficiaries who inherit it can still make qualified tax-free withdrawals.
Your financial situation and goals determine whether you can opt out of a Roth conversion and the pro-rata rule. It’s always best to seek the appropriate guidance on how to move forward with the best plan for your financial future.
Call the Pros at Asset Preservation Wealth & Tax
A Roth conversion may not be suitable for your situation. The primary goal in converting retirement assets into a Roth IRA is to reduce the future tax liability on the distributions you take in retirement, or on the distributions of your beneficiaries. The information provided is to help you determine whether or not a Roth IRA conversion may be appropriate for your particular circumstances. Please review your retirement savings, tax, and legacy planning strategies with your legal/tax advisor to be sure a Roth IRA conversion fits into your planning strategies.
Any comments regarding safe and secure investments and guaranteed income streams refer only to fixed insurance products. They do not refer in any way to securities or investment advisory products. Fixed insurance and annuity product guarantees are subject to the claims paying ability of the issuing company; not guaranteed by any bank or the FDIC.
Stewart Willis is the founder and president of Asset Preservation Wealth & Tax, a financial planning firm in Phoenix, Arizona. Investment advisory services offered through Foundations Investment Advisors, LLC, an SEC registered investment adviser.
The commentary on this blog reflects the personal opinions, viewpoints and analyses of the author, Stewart Willis, providing such comments, and should not be regarded as a description of advisory services provided by Foundations Investment Advisors, LLC (“Foundations”), an SEC registered investment adviser or performance returns of any Foundations client. The views reflected in the commentary are subject to change at any time without notice. Nothing on this website constitutes investment, legal or tax advice, performance data or any recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person. Personal investment advice can only be rendered after the engagement of Foundations for services, execution of required documentation, including receipt of required disclosures. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. Foundations manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Any statistical data or information obtained from or prepared by third party sources that Foundations deems reliable but in no way does Foundations guarantee the accuracy or completeness. Investments in securities involve the risk of loss. Any past performance is no guarantee of future results. Advisory services are only offered to clients or prospective clients where Foundations and its advisors are properly licensed or exempted. For more information, please go to https://adviserinfo.sec.gov and search by our firm name or by our CRD # 175083.
