MONEY

Moisand: Understanding an IRA ‘gotcha’

Dan Moisand

In my last column, about some of the things to consider when contemplating whether to rollover a 401(k) to an IRA, I mentioned I would explain the “pro-rata rule”, a notorious “gotcha” in the tax code.

I wrote, “At any age, if you have other IRAs and have made non-deductible contributions to any of them in the past, and plan to make IRA withdrawals or convert traditional IRA funds to Roth IRAs, you may wish to leave the money in the 401(k). Leaving the money in the 401(k) helps alleviate issues stemming from the notorious pro-rata rule.”

Here is an oversimplified example to illustrate the rule’s effect.

Say you rollover $70,000 from a 401(k) all pre-tax to IRA-A and you already had $30,000 in IRA- B that was funded with $20,000 of after-tax contributions. Some people will refer to B as a “non-deductible IRA” and want to convert it to a Roth IRA. If you do that, you will have IRA A with $70,000, a Roth IRA with $30,000, and an empty IRA-B.

You might think you owe taxes on $10,000 of income, the untaxed amount of IRA-B that was converted. You’d be wrong.

There is no such account type as a “non-deductible IRA” in the tax code. There are only non-deductible contributions to a traditional IRA. To add to the confusion, Form 8606, the form used to track and report all this is actually titled “Non-deductible IRAs”. The code treats all your IRAs as one IRA. The after-tax contributions are allocated pro-rata across all accounts.

After your conversion, you have $70,000 in IRA-A and a $30,000 Roth IRA but you owe tax on $24,000 of income not $10,000. The $20,000 of after-tax contributions is compared to the balance of all the IRAs. So, $20,000/$100,000 = .20. Multiply the $30,000 converted by .20 and you get $6,000. That $6,000 represents a pro-rata share of the after-tax contributions so $30,000 less the $6,000 already taxed amount leaves $24,000 to be taxed.

Further, the IRA-A is now deemed to hold the remaining $14,000 of after-tax contributions ($20,000-$6,000). That $14,000 figure is used against the future balance of all IRAs to determine the taxable portion of future distributions or conversions.

Dan Moisand, CFP, is a past national president of the Financial Planning Association and has been featured as one of America’s top financial planners by at least 10 financial planning publications, dan@moisandfitzgerald.com 321-253-5400, ext. 101