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What You Can Do To Avoid The IRA Pro-Rata Rule · Retirement Answers

• 0:00
  Jacob: Hey, friends, and welcome back to another Friday Q and A here on the Retirement Answers podcast. I hope you have had a wonderful week. Let's go ahead and jump into this week's question. It comes in from James, and James says, my question is for an after tax contribution to a traditional IRA. Me and my spouse both have traditional IRAs with about $30,000 of after tax contributions in these accounts.
• 0:22
  Also, have traditional IRAs that only have deductible contributions in a separate account. I've heard about the Pro Rata rule, but how or can we even separate the after tax contributions so this would make it easier later to deal with the distributions? Thank you, James. James, that's a great question. The Pro Rata rule is something that catches a lot of people off guard, And most of the time, simply just don't know about it and they just pay double taxes on the after tax money that's in the IRA to begin with.
• 0:48
  So a few different things here. Number one is sometimes people think that, oh, I've got two separate IRAs. One of them is tax deferred and one of them is after tax. Therefore, I can just draw from one or the other and pay taxes accordingly or I don't have to pay taxes because the money's separate, they're in different accounts. And logically, would make sense in our minds.
• 1:07
  But from the IRS's perspective, they view all IRAs as one big lump account, whether you have 10 different IRAs or you have one, all of those are combined into one total from a tax perspective. So if you take $10,000 out of the $30,000 in this scenario here that you've explained, and that 30,000 is after tax money, if you take 10,000 out of that specific account, guess what? You're not going to avoid paying taxes on a portion of that because it also considers whatever other amount you have in your other IRAs that is pre tax money. So the pro rata rule does apply in this scenario and it applies to all accounts globally in the IRA sense. So that's not a solution.
• 1:46
  You can't just do a conversion on one account and expect to pay no taxes because the pre tax and after tax dollars are separated, that won't work. So here's maybe the best solution for you. If you are still working, the best case scenario would be for you to roll over your pre tax IRA into your current four zero one ks, and then once that account balance is zeroed out, then you can convert all the after tax money and what's left over in that separate IRA to your Roth, and you'd pay no taxes on that because there's no more pre tax money in an IRA because that money is now in your four zero one ks. Now there's a few things to pay attention to here. Number one, you've got to make sure that your four zero one ks actually accepts rollovers into the four zero one ks as opposed to only rollovers out.
• 2:32
  So normally people roll money out of four zero one ks's into an IRA, rarely do they put it back in via rollover. So that's something you have to pay attention to and figure out if your four zero one ks specifically allows it. The other thing here is that you need to make sure that you pay attention to form 8,606 and file that correctly, or make sure you've talked to a tax repair or a CPA or somebody who can help you with this because it does get a little bit complicated because if you do that conversion on the $30,000 of after tax money, the IRS is gonna think that money is taxable, although it's not gonna be subject to taxation because it's after tax money that went into the account. But the key is you have to have that documented through form 8,606, and I've talked about this in previous episodes, but you've got to have that filed for hopefully the years in which you made the contributions and you've got to be able to keep track of that so that you have this balance to offset against your $30,000 that you would be converting. Now, the other key here is this, if you're able to do all the steps so far that I've mentioned, you've got to make sure not to roll over any money back into an IRA before the end of the year, because here's the thing, the pro rata rule is based on whatever account balances are in your IRAs at the end of the calendar year.
• 3:38
  So here's an example. Let's say that you were able to roll over your pre tax money that you have in the IRAs into your four zero one ks right now today, and then you did your conversion on the after tax money, so that's all now in the Roth, and then later this year, let's say just in October, you rolled the money out of your four zero one ks back into your IRA, and that is all pre tax money. Guess what? You're still going to have a pro rata rule issue because they're going to have a balance in your traditional IRA at the end of this calendar year. You would have to wait until the next calendar year to do any sort of rollovers into an IRA to avoid this pro rata rule.
• 4:09
  So the order in which you do all this absolutely matters, but just because you've completed the conversion doesn't mean you can roll the money back into your IRA just yet. You've got to wait for this tax year to pass so that you have a zero balance at the end of the calendar year, and you can do that rollover in the following year. So there are a few different things to look at here. There's a lot to navigate. I would probably recommend that you talk with your tax repair or your financial advisor or somebody because this is very confusing and you want make sure that you do all this correctly.
• 4:37
  But the best way is to roll that into a current four zero one ks if you're able to or any sort of employer sponsored plan that will accept it. If you're retired, it does get a little more complicated because you have less options. Obviously, you don't have an employer sponsored four zero one ks or plan to roll the money into. So you might just simply have to keep track of your basis and do the calculations on that and be able to prove what you do or don't owe taxes on as you make distributions or do Roth conversions. The key there is simply making sure you keep track of this and are able to document what you do and don't owe taxes on based on your form 8,606 and all the after tax money that you've contributed to your IRAs over time.
• 5:14
  The thing here is that the pro rata rule isn't the worst thing in the world. It's not like you're losing money because of the pro rata rule, it's just harder to maintain and administer and keep track of because of these percentages of account balances and what, how many dollars of your distribution or your Roth conversion are subject to tax and how many dollars aren't as a percentage of the account balances. And obviously it's a headache to navigate. So if you want to get out of pro rata rule issues, get all your pre tax money into an employer plan, do the conversion on that after tax money that's in the IRAs, wait one calendar year, roll the money back out into your traditional IRA, and then you're good to go because then your traditional IRA has all pre tax money, and your Roth obviously has Roth money. So that's the ideal way to do it.
• 5:56
  If you are not working, you don't have the opportunity to use an employer sponsored four zero one ks plan, probably just need to keep track of how much you do have in pre tax and after tax money in your IRA accounts, then obviously do some math every year as you file taxes on that to make sure you don't double pay if you don't want to double pay. Now, here's the final thing I'll say, if you've got $30,000 in after tax money in an IRA and you've got a million dollars in pre tax money in an IRA, the juice might not be worth the squeeze on the administrative portion of this and all the accounting to keep track of 3% every single year of any distribution or conversion is actually what's not taxable. It might be easier to simply pay tax on that. Basically, you're paying taxes twice, and then find a different way to offset that or find some other tax deductions or some other planning strategy to reduce your taxes to account for that. So there's some element of, hey, is it actually worth the hassle here to figure all this out and maybe pay people to do it for you?
• 6:56
  Or would how much I'm paying someone like a CPA to actually do all this not even be worth how much benefit I'm gonna get by not paying the taxes again. So there is a little bit of nuance and it just depends on how much of a percentage of all of your IRA balances is after tax money. If it's large percentage, obviously that'd well worth keeping track of this and doing this correctly. If it's a really small percentage, one or 2%, then it might not be worth the hassle of going through all of these hoops and figuring this stuff out. James, I really appreciate the question.
• 7:24
  This is one that a lot of people end up having, because at some point throughout a career, someone's made after tax contributions to an IRA simply because they either made too much money to make a deductible contribution to that IRA and they couldn't do Roth, or they just had some after tax money in a four zero one ks and rolled that money into a traditional IRA. So there's plenty of ways that this could happen and it's not uncommon. So this hopefully is helpful for not just you James, but everyone else listening and also shows, hey, if we can try to avoid this, so you don't have this huge accounting problem later down the road, especially when you get to retirement and you don't have as many solutions to help figure it out. So hope that helps. James, thanks for the question.
• 7:58
  I hope everyone has a great weekend and we will talk to you again next week. Hey, it's Jacob again, and I wanted to remind you that nothing discussed in today's episode is meant to be financial, legal, or tax advice. Retirement Answers is for educational purposes only. Thanks for tuning in to this week's episode. I look forward to talking with you again next week.