The pro rata rule seems to be something that gives investors some pause and concern. I think because anytime that there is a financial “rule,” investors worry excessively about doing something wrong and enduring some financial calamity. I can relate because this pro rate rule was a concern of mine previously when I started learning about investing.
Turns out that I worried about something pretty minute and easy to deal with.
So, in this post, I’d like to break down the pro rata rule, what it is, what it isn’t, and how to manage it with your investing.
What is the pro rata rule?
The pro rata rule has to do with how tax deferred or “deductible” money is handled and taxed upon withdrawal or conversion.
As such, the rule applies to accounts with deductible money, namely traditional 401(k)s, traditional IRAs, SEP IRAs, and SIMPLE IRAs.
Most people tend to think of this rule as only applying to conversions, specifically related to backdoor Roth contributions. But really the pro rata rule is broader than that and dictates how tax deferred money in general is managed after any withdrawal.
So let’s look at withdrawals first since it helps simplify things
“Pro rata” is really just the percentage of funds in a (tax deferred account) that is actually tax deferred.
So, to calculate the pro rata, you just use the below equation:
(Non-deductible amount) / (Total of all non-Roth IRA balances) = Non-taxable percentage (pro rata)
Next, to find out how the IRS will tax your money withdrawal, just multiply this “pro rata” by the amount of money you are withdrawing.
(Amount withdrawn) x (Non-taxable percentage AKA pro rata) = Amount of withdrawal that will be taxed at your (usually marginal) tax rate
So let’s run a quick example
You have a traditional IRA with $100,000 in it. And of that $100,000, $10,000 comes from non-deductible (non-deferred) contributions for whatever reason. Maybe you contributed to the traditional IRA above contribution limits or when your income was above the threshold for tax benefits. Doesn’t matter why for the sake of the example.
In this case, your “pro rata” percentage is $10,000/$100,000 or 10%. Therefore no matter what amount you withdraw, for tax purposes, 10% will be considered non-deductible (won’t get taxed). Meanwhile, 90% will get taxed (because it is deductible in the eyes of the IRS).
Re-read that last part to make sure it all makes sense in your mind.
Now, a lot of times, the pro rata rule doesn’t really end up mattering
Because most investors will follow an investment account waterfall and only contribute up to the maximum allowable amount in a tax deferred account.
So their “pro rata” is 0% and all withdrawals are deductible. This is especially true for 401(k) retirement accounts.
Or, in the case of high income earners, we often aren’t investing at all in the other accounts that these the pro rata rule applies to. Namely, traditional IRAs, SEP IRAs, or SIMPLE IRAs. Because they are less common, available only to 1099 physicians in the case of SEP and SIMPLE IRAs, or because we are above income limits for tax benefits in the case of a traditional IRAs.
But the pro rata rule does come into play in one very specific and relevant situation
And that situation is the backdoor Roth conversion. (If you are not familiar with the Backdoor Roth conversion, check out this post.)
For most high income earners, the only reason or time that they will invest in a traditional IRA is as a transitory account only before converting it to a Roth IRA. However, this conversion is subject to the pro rata rule.
Now, for many physicians, this won’t affect them.
Take me for example. I’m a W2 physician. So, besides a 403(b), I don’t invest in any other tax deferred accounts. Thus, when I make my annual contribution to a traditional IRA and convert it to a Roth IRA 1 day later, my “pro rata” percentage is 0%.
So, no pro rata to worry about.
However, many physicians have 1099 income in addition to or exclusive to W2 income. And many of these physicians may have associated SEP, SIMPLE, or traditional IRAs.
And in that case, the pro rata rule matters very much. Because without being aware of it, these investors may find an unwanted tax bill.
To see why, let’s go back to our previous calculation. If an investor has $100,000 in a SEP-IRA and then wants to add $5,000 to a traditional IRA to convert to a Roth IRA via the backdoor, their actual “pro rata” percentage for that conversion is $5,000/$105,000 or roughly 5%.
Therefore, of that $5,000 that they convert to a Roth, only 5% is non-deductible in the eyes of the IRS and 95% is deductible. So they will owe taxes on 95% of that conversion.
And that defeats the whole purpose of why you would be doing the backdoor Roth in the first place!
How can you avoid the pro rata rule?
Now that you can see why the pro rata rule can rarely turn into a real headache, let me assure you that there is a really easy solution.
And to understand why, we first have to establish that when applied to a backdoor Roth IRA conversion, the rule only applies to other tax deferred IRA accounts.
So, if you have a traditional IRA or SEP-IRA and want to contribute to the backdoor Roth without going afoul of the pro rata rule, simple convert that tax deferred IRA account to another tax-deferred 401k account. Like a solo-401k or the like.
Now, with your deductible IRAs all now cleared out, you can make your Backdoor Roth conversion without worry or hidden tax implications.
So, there you have it
The pro rata rule is not so scary, right?! Like most things, these rules and regulations seem a lot more complex than they really are.
And really, the pro rata rule makes sense. It’s in place to ensure that investors don’t accidentally or purposefully get their money tax deferred and tax free at the same time (as sweet as that would be).
Like most things, you can manage this aspect of your investments yourself. But if you still worry about it, consult with a tax advisor. I use Cerebral Tax Advisors and they are fantastic.
And for more help optimizing your investing strategy, check out these posts!
- Do Your Finances Pass the Celery Test?
- 5 Reasons You Still Need to Max Out Your 401k
- Evaluating the Two Funds for Life Portfolio for Doctors
- 5 Ways W2 Physicians Can Lower Their Tax Burden
What do you think? Is the pro rata rule unfair? Does it make sense? Does it even apply to you? Let me know in the comments below!