Backdoor ROTH IRA Contributions: Pro Rata Rule
When you consider retirement account contributions, most people have heard of making contributions to an Individual ROTH IRA. A ROTH IRA is a retirement vehicle that allows you to make after-tax contributions up to $7,000 ($8,000) in 2024.
The growth and eventual withdrawal of these contributions can be 100% tax free as long as the ROTH has been open for 5 years, and the participant is over age 59.5. As a general note, you can always take out your contributions tax-free from the ROTH, since they have already been taxed, just not the earnings until the above two rules are satisfied.
Sounds like a good deal, right? While it certainly is, it is important to recognize that the IRS puts limits on the level of income you can have and still be eligible to contribute to an Individual ROTH IRA – there is no income limit on contributions to ROTH 401ks. For 2024, you need to have Modified Adjusted Gross Income (MAGI) of under $146,000 (single) and $230,000 (married) to make full contributions to a ROTH IRA. If you make above the top of the phase out level ($240,000 for married & $161,000 for single), you cannot make any contributions.
So, if you make too much money for contributions to an individual ROTH, you may consider utilizing the backdoor ROTH IRA strategy.
This essentially allows you to make non-deductible contributions into an IRA (monies you already paid taxes on, then convert these funds over to ROTH via the backdoor while not being subject to the income limit – the contribution limits of $7,000/year ($8,000 if over age 50) still apply.
Additionally, once you contribute funds into the Traditional IRA, it is good practice to wait at least a month prior to moving the funds to ROTH in order to have the nondeductible contribution show up on your statement for recordkeeping purposes. It could also be a good idea to close out the IRA after the move to ROTH to not have any lingering Traditional IRA accounts (more on this below).
In any case, while this is an awesome strategy, there are a few important rules to keep in mind, which is why you should always consult with a qualified tax professional prior to taking action.
Outstanding IRA Balances / Pro-Rata Rule
In order for this to work out nicely, you will need to make the nondeductible contribution into a traditional IRA, then have your Accountant / CPA file Form 8606 with your tax return to let the IRS know that the contribution should be consider nondeductible – very important!!
Moreover, this contribution should be made to a Traditional IRA that does not have an existing balance - you also should not have any other outstanding pre-tax IRA accounts (this includes SEPs & Simple IRAs) with balances – employer plans (401k & 403b) do not apply here. Otherwise, this backdoor ROTH contribution could become a taxable event – let me explain.
Pro-Rata Rule
Simply stated, the pro-rata rule is used to determine the tax liability when a distribution is taken from an IRA account that has both pre-tax and after-tax contributions. If you simply open the IRA to make the nondeductible contribution then move to ROTH, close the IRA, and file Form 8606, and do not have any other IRAs outstanding, then you should have no problem here.
This becomes more complicated if you have other IRA accounts with pre-tax monies, as the pro-rata rule takes ALL of your IRA balances into consideration when going through this calculation to determine tax liability.
To drill down on this, let’s assume I completed a backdoor ROTH contribution for $7,000 (maximum amount) in 2024 using my IRA open this year, however, I forgot that I have $5,000 in another IRA I opened many years ago – these contributions were made on a pre-tax basis.
As stated above, the pro-rata rule looks at all IRA assets when calculating a tax liability – both nondeductible and deductible contributions. Therefore, the $5,000 makes up approximately 41.7% ($5,000 divided by $12,000) of my overall IRA balances, so 41.7% of the contribution via backdoor ROTH will be taxable. This was not the intended action, since the nondeductible contribution was already taxed, and a tax break was received on the pre-tax contributions years ago.
How to avoid the pro-rata rule
Referring back to the beginning of this post, a simple way to avoid the pro-rata rule is to ensure you do not have any lingering IRA balances when implementing the backdoor ROTH IRA strategy.
If you do have other IRA’s outstanding, you could consider rolling these balances into your current 401k plan (if your plan rules permit this) by December 31st of the calendar year you complete / intend to complete this strategy. This would clean up the balances and allow for the backdoor ROTH to transpire as planned.
Furthermore, if it makes sense for your situation, you could consider converting these other pre-tax IRA balances into ROTH and paying the appropriate tax along the way – i.e. a ROTH conversion. Unlike the limits on ROTH contributions, there is currently no limit on the amount you can convert to ROTH.
As we close out this discussion, I hope this was helpful in understanding what the backdoor ROTH strategy is, why folks consider it, and how to execute it properly to avoid any hiccups or surprise tax bills 😊. Happy planning!
For a comprehensive review of your personal situation, always consult with a tax or legal advisor. Neither Cetera Advisor Networks LLC nor any of its representatives may give tax or legal advice.