Maxing out your 401k or retirement accounts sounds like a major financial win, but even great savers can make costly retirement account mistakes. In this episode of the Wise Money Show, we break down common retirement contribution mistakes involving catch-up contributions, employer matches, Roth rules, and income limits. Learn how to avoid missed opportunities, unexpected tax problems, and other errors while making the most of your retirement savings.
Season 12, Episode 5
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This information is for general financial education and is not intended to provide specific investment advice or recommendations. All investing and investment strategies involve risk, including the potential loss of principal. Asset allocation & diversification do not ensure a profit or prevent a loss in a declining market. Past performance is not a guarantee of future results. This video may discuss estate planning concepts but does not constitute legal advice. Please consult an attorney for advice specific to your situation.
The Pro-Rata Rule: One of the Most Overlooked Retirement Account Mistakes
Contributing to a Roth IRA can be a great way to build tax-free income for retirement. But if your income is too high to contribute directly, you may consider a strategy called a backdoor Roth IRA.
The process sounds simple: contribute after-tax dollars to a traditional IRA, then convert those dollars to a Roth IRA. However, there’s an important tax rule that can complicate this strategy.
It’s called the pro-rata rule, and misunderstanding it is one of the retirement account mistakes that could leave you with an unexpected tax bill.
What Is the Pro-Rata Rule?
The pro-rata rule determines how much of an IRA distribution or Roth conversion is taxable when you have both pre-tax and after-tax money in your traditional IRAs.
Here’s the catch: You can’t simply choose to convert only your after-tax dollars.
Instead, the IRS generally treats your conversion as a proportional mix of pre-tax and after-tax money across your traditional IRAs.
That means even if you’ve already paid taxes on your contribution, part of your Roth conversion could still be taxable.
How Does the Pro-Rata Rule Work?
Let’s look at an example.
Suppose you have $93,000 in an existing traditional IRA, all pre-tax money. You then contribute $7,000 in after-tax dollars to a traditional IRA, intending to convert that contribution to a Roth IRA.
You now have $100,000 in traditional IRA assets:
- $93,000 in pre-tax money
- $7,000 in after-tax money
Only 7% of your total IRA balance is after-tax money.
If you convert $7,000 to a Roth IRA, only $490 (7%) is tax-free. The remaining $6,510 is taxable, assuming no other distributions or changes in account values.
What you expected to be a tax-free conversion has now created a taxable event.
Disclosure: This example is for illustrative purposes only. The figures are hypothetical and are intended to demonstrate how the pro-rata rule works. Actual tax implications may vary based on individual circumstances, account balances, and applicable tax laws.
Which Accounts Count Toward the Pro-Rata Rule?
One of the most common retirement account mistakes is assuming the rule only applies to the IRA you’re converting.
The IRS generally considers the combined value of your:
- Traditional IRAs
- SEP IRAs
- SIMPLE IRAs
Even if these accounts are held at different financial institutions, they’re generally included in the calculation.
However, employer-sponsored retirement plans like 401(k)s and 403(b)s aren’t included in your IRA balance for this purpose.
Can You Avoid the Pro-Rata Rule?
You can’t ignore the rule, but there may be ways to reduce its tax impact.
For example, if your employer’s 401(k) accepts eligible IRA rollovers, you may be able to move pre-tax IRA dollars into that plan, leaving after-tax dollars available for conversion.
Timing also matters. The IRS generally considers your IRA balances on December 31 of the conversion year, along with distributions made during that year.
It’s also important to properly report nondeductible IRA contributions using IRS Form 8606. This tracks your after-tax basis and helps prevent you from paying taxes twice on the same money.
Make Sure Your Roth Strategy Fits Your Financial Plan
A backdoor Roth IRA can be a valuable retirement savings strategy, but it isn’t automatically the right choice for everyone.
Before converting, consider your existing IRA balances, current tax bracket, and overall retirement strategy.
At Korhorn Financial Group, we believe retirement planning and tax planning should work together. Understanding rules like the pro-rata rule can help you avoid unnecessary taxes and costly retirement account mistakes.
Want to make sure your retirement strategy is working for you? Learn more about our comprehensive financial planning services at korhorn.com.
