Detailing the Pro-Rata Rule

For IRA distribution purposes, all IRAs (except Roth IRAs) are considered one big giant IRA. It doesn’t matter if you have one IRA that was rolled over from a former employer, and one SEP IRA with your current employer, and one contributory IRA where you put annual contributions, and one after-tax IRA where you put contributions for which you do not take a deduction. All four IRAs will be considered one IRA any time you take a distribution.

Since they are all one IRA for distribution purposes, you cannot separate out any one component of your IRAs. You cannot take out or convert only the after-tax funds in your IRA. All distributions or conversions will be treated pro-rata.

You track your after-tax IRA funds on IRS Form 8606. The form must be filed with your tax return in any year that you make an after-tax contribution (or rollover after-tax funds from an employer plan to your IRA), and it must be filed in any following year when you take a distribution from your IRA. The form will calculate the amount of your distribution that is taxable.

Put simply, the form takes the total year-end balance of all your IRAs and divides that into the total balance of all after-tax amounts in all IRAs. The resulting percentage is then applied to the distribution to determine the tax-free portion of the distribution. The remaining balance of the distribution is taxable. The tax-free amount of the distribution will reduce the total after-tax amount carried forward to your next Form 8606.

Example: John has a rollover IRA from a previous employer of $270,000 and an “after-tax” IRA account with $30,000 of total contributions in it. John takes a distribution of $30,000 from his after-tax account and converts it to a Roth IRA. His total account balance is $300,000 ($270,000 + $30,000 = $300,000). 10% of his distribution will be tax free ($30,000 / $300,000 = 10%). He will pay income tax on $27,000 ($30,000 X 10% = $3,000 tax free, balance $30,000 - $3,000 = $27,000 taxable). Even though he has closed his after-tax IRA, his rollover IRA balance will now include the remaining after-tax balance of $27,000 ($30,000 after-tax balance - $3,000 distributed = $27,000).

As you can see from the calculation, it won’t matter what IRA account you take the distribution from. Some of the distribution will be taxable and some will be tax-free. The overall totals of your pre-tax and after-tax amounts will be reduced without regard to the account the funds came from.

This is another installment in our weekly look at The Slott Report's "Best of 2013". New articles return next week!

-By Beverly DeVeny and Jared Trexler

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Slott Report Mailbag: What Happens If I Name a Minor as My IRA Beneficiary?

This week's Slott Report Mailbag looks at naming minors as IRA beneficiaries, something we cover in some depth in other articles, as well as the RMD (required minimum distribution) rules around annuities. As always, we stress the importance of working with a competent, educated financial advisor to keep your retirement nest egg safe and secure. Find one in your area at this link.

1. If you make a non-deductible IRA contribution, can that amount be converted to a Roth IRA tax-free if you have a 401(k)?

Answer:

Send your questions to [email protected]

Having a 401(k) plan doesn’t affect the taxation of an IRA conversion. The taxation depends on whether or not you have any other IRA funds, including SEP and SIMPLE IRA funds. The pro-rata tax rule applies, which means if you do have other IRA funds that contain pre-tax money, then the conversion of the non-deductible IRA contribution amount won’t be tax free. It will be partially taxable and partially tax free using the percentage of your pre-tax funds in all your IRAs to all your after-tax tax amounts (such as nondeductible contributions). You will have to file Form 8606 with your income tax return to report the conversion and to do the pro-rata calculation. You can find the form on the IRS website, www.irs.gov. Click on “Forms and Publications.”

2. If I were to purchase an immediate annuity with all the funds in my only taxable IRA, what impact does that have on RMDs (required minimum distributions) when I'm age 70 1/2?

Answer:
IRA annuities must meet the RMD rules; however, depending on the type of annuity you buy, the RMD amount may be larger than the RMD if you didn’t buy an annuity. When an IRA annuity starts paying out, (“annuitizes”) the annual distributions are the RMD for the annuity.

3. In your books you talk about leaving a Roth IRA to grandchildren to stretch the IRA. Are minor grandchildren permitted to inherit assets from a Roth IRA? If the IRA were invested in mutual funds, what would happen to them if I die while the grandchildren are minors?

Thank you for your assistance.

Sincerely,

Martha Willis

Answer:
Minors can be the beneficiaries of any IRA, including a Roth IRA. Regardless of what the IRA is invested in, upon your death, your grandchildren will need to take death distributions, typically over their own single life expectancies. Those Roth IRA distributions generally will be tax free to them. However, there is a problem. Minors cannot sign IRA agreements, manage investments, or manage the distributions that come out of the IRA. You will need to have a guardian or a trust in place to do this for the minors. You should check with your IRA custodian to see what their procedures are when a minor inherits an IRA, and you may need to consult with an attorney about setting up a trust. Be sure to ask an attorney about their IRA knowledge and how or where they acquired that knowledge. An improperly drafted trust or the wrong moves after your death can mean the end of the IRA with income tax being due all at once.

- By Joe Cicchinelli and Jared Trexler

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Slott Report Mailbag: Can I Convert My Non-Deductible IRA Contributions to a Roth IRA?

This week's Slott Report Mailbag discusses Roth IRA contributions, conversions and the availability of certain employer-sponsored retirement plans.  As always, we stress the importance of working with a competent, educated financial advisor to keep your retirement nest egg safe and secure. Find one in your area at this link.

1.

For the last 15 years, I have been putting money in my traditional IRA. I have also been maxing out on my pension at work. Since I never took a deduction for my IRAs, I would like to transfer my traditional IRA to a Roth IRA. What difficulties will I have with the IRS?

John Di Paolo

Answer:

Send questions to [email protected]

You should have no problem converting your non-deductible IRA contributions to a Roth IRA as long as you have been filing IRS Form 8606 with your tax return in each year that you made a non-deductible contribution. The conversion of IRA funds to a Roth IRA is taxable. Because you have non-deductible contributions, those amounts aren’t taxed when they are converted but the earnings will be. There is a pro-rata rule that will apply at the time of your conversion. It can be found on Form 8606. All of your IRA accounts are looked at as one account and will be part of the pro-rata calculation. Your conversion to a Roth IRA will be partly taxable and partly after-tax based on the ratio of all of your after-tax amounts divided by the total balances in all your IRA accounts.

2.

Hello,

Can I contribute to my company 401(k), Health Savings Account (HSA), and a Roth IRA in the same tax year? If so, what are the income and contribution limits?

My wife and I are both in out middle 50s and have an AGI (adjusted gross income) of about $100,000 annually. For 2013: 8% of my paycheck is withheld for our company 401(k) (maximum % the company will match funds). I have $6,500 that will be funding a HSA and would also like to contribute to a Roth IRA (if tax code permits).

Michael in Mount Vernon

Answer:
There are no income limits to contribute to a 401(k), however, the income limits for contributing to a Roth IRA for 2013 are $178,000 - $188,000 if you file jointly. The tax code allows you to contribute to all three if you meet the requirements for all of them.

3.

If a company already has a SEP IRA, can they contribute to an IRA for certain employees as well?

Best regards,

Stacey

Answer:
Yes. An employer-sponsored IRA arrangement allows an employer to contribute to IRAs of any employees he or she chooses. The IRA contribution is treated as wages to the employees.

-By Joe Cicchinelli and Jared Trexler

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Slott Report Mailbag: What Does the Pro-Rata Rule Take Into Account?

This week's Slott Report Mailbag includes questions on the always-complicated Roth IRA 5-year rules and the pro-rata rule. As you can see, this is just the tip of the iceberg when it comes to IRA planning rules. As always, we stress the importance of working with a competent, educated financial advisor to keep your retirement nest egg safe and secure. Find one in your area at this link.

1.

Hey guys,

Send questions to [email protected]

I was reading some info on your pages, it is very informative. Regarding the Roth IRA 5-year rule, I had some questions.

If I withdraw funds from my Roth IRA (or 401(k)) and my first contribution is credited to tax year 2008 I have met the 5-year period. I am 33 years old (not 59 1/2). Assuming I have $5k in basis and $2k in earnings and decide to withdraw all of it, should it be ALL tax-free? Otherwise, what is the point of the five year rule if you are not 59 1/2? Would I owe a 10% penalty on this? I feel that this subject is never approached from this standpoint no matter which resource I use. I hope you can help. Thanks.

-AJ, Ohio

Answer:
The 5-year period has been met as of January 1, 2013. If you take a distribution from your Roth IRA this year at age 33, the $2K of earnings will be taxable because it’s a non-qualified distribution. Although the 5-year period has been met, you must also be dead, disabled, age 59 ½, or buying a first home for the earnings to be tax-free. You’ll also owe a 10% penalty on the $2K of earnings, unless an exception applies. The $5K of basis is tax and penalty free.

If the $7K distribution is from your Roth 401(k), it is a non-qualified distribution. Although the 5-year period has been met, you must also be either age 59 ½, dead, or disabled. The earnings portion ($2K) is taxable but the basis is tax-free.

Although in your example, the taxation is the same for both a Roth IRA and Roth 401(k), it should be noted that rules for Roth 401(k)s and Roth IRAs are different, and a different example would yield different results.

2.

Dear Sir/Madam,

Many years ago when I started contributing to my 401(k), the only option available for contribution was "after-tax dollars". My employer provided work sheets to track my contributions, their match and yearly earnings in the account. The idea, as I understood it then, was that at time of withdrawal one could take distributions up to one's contributions tax free. Any amount distributed exceeding those after tax contributions, presumed to be earnings, would be taxed at ordinary rates. After a number of years contributing to the "after tax" 401(k)", my employer introduced the "before tax" 401(k). At that point I switched my contributions from the "after tax" to "before tax" and have continued to the present.

My question is: Upon distribution will the "pro-rata rule" apply to my "pre-tax" 401(k) distribution or just the earnings achieved on the "pre-tax" contributions? I'm aware of the 10% penalty if withdrawn prior to 59.5 years of age, (I'm 56) but want to understand how the rule applies to my long ago contributions to the "after tax" 401(k). I am evaluating the option of rolling over these "after tax" funds into a Roth IRA and want to understand the tax implications. I learned a lot from reading "The Retirement Savings Time Bomb...and How to Defuse it" but was not certain how the pro-rata rule applies to a 401(k). I understand how it applies to the mix of "before" and "after" tax in an IRA but not sure if it applies equally to the 401(k), particularly to funds contributed prior to the "before tax" 401(k) came into existence. Any guidance you can provide is appreciated.

Thank you,

Manuel Valdes

Answer:
When converting plan funds to the Roth IRA, only the pre-tax funds are taxable. The only way to roll over (convert) just the after-tax amount to a Roth IRA tax-free would be to receive your entire 401(k) balance payable to you and use the 60-day rollover rule to first move your pre-tax funds to an IRA and then move the after-tax funds to a Roth IRA. However, the 20% withholding rules will apply to the 401(k) distribution. To complete your rollover, you will need to be able to replace the withheld amounts with personal funds. The issue of separating pre-tax and after-tax employer plan money is complex and should be addressed with a tax adviser with experience in employer plan rules. There are also different rules for after-tax contributions made before 1987 and after-tax contributions made after 1986, if they are separately accounted for by your employer.

3.

I have been doing backdoor Roth contributions for several years, but have not done my 2012 or 2013 contributions/conversions yet. I will most likely roll over a 401(k) into an IRA in 2013. If I convert a traditional IRA to a Roth now and then do the 401(k) rollover later in the year, will I need to pay pro- rata taxes on the converted amount? Essentially, are taxes calculated using my pre-tax IRA holdings at the time of the conversion (none) or at the end of the tax year?

Thanks for your help.
Kate

Answer:
The pro-rata rule will take into account any funds rolled into the IRA during the year.

-By Joe Cicchinelli and Jared Trexler

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Roth Conversions and the Pro-Rata Rule

For IRA distribution purposes, all IRAs (except Roth IRAs) are considered one big giant IRA. It doesn’t matter if you have one IRA that was rolled over from a former employer, and one SEP IRA with your current employer, and one contributory IRA where you put annual contributions, and one after-tax IRA where you put contributions for which you do not take a deduction. All four IRAs will be considered one IRA any time you take a distribution.

Since they are all one IRA for distribution purposes, you cannot separate out any one component of your IRAs. You cannot take out or convert only the after-tax funds in your IRA. All distributions or conversions will be treated pro-rata.

You track your after-tax IRA funds on IRS Form 8606. The form must be filed with your tax return in any year that you make an after-tax contribution (or rollover after-tax funds from an employer plan to your IRA), and it must be filed in any following year when you take a distribution from your IRA. The form will calculate the amount of your distribution that is taxable.

Put simply, the form takes the total year-end balance of all your IRAs and divides that into the total balance of all after-tax amounts in all IRAs. The resulting percentage is then applied to the distribution to determine the tax-free portion of the distribution. The remaining balance of the distribution is taxable. The tax-free amount of the distribution will reduce the total after-tax amount carried forward to your next Form 8606.

Example: John has a rollover IRA from a previous employer of $270,000 and an “after-tax” IRA account with $30,000 of total contributions in it. John takes a distribution of $30,000 from his after-tax account and converts it to a Roth IRA. His total account balance is $300,000 ($270,000 + $30,000 = $300,000). 10% of his distribution will be tax free ($30,000 / $300,000 = 10%). He will pay income tax on $27,000 ($30,000 X 10% = $3,000 tax free, balance $30,000 - $3,000 = $27,000 taxable). Even though he has closed his after-tax IRA, his rollover IRA balance will now include the remaining after-tax balance of $27,000 ($30,000 after-tax balance - $3,000 distributed = $27,000).

As you can see from the calculation, it won’t matter what IRA account you take the distribution from. Some of the distribution will be taxable and some will be tax-free. The overall totals of your pre-tax and after-tax amounts will be reduced without regard to the account the funds came from.

-By Beverly DeVeny and Jared Trexler

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Inherited IRA Rules, Pro-Rata Tax Rule Highlight Mailbag

This week's Slott Report Mailbag includes your questions (and our answers) on inherited IRA distributions, SEP IRAs and the pro-rata tax rule. As always, we stress the importance of working with a competent, educated financial advisor to keep your retirement nest egg safe and secure. Find one in your area at this link.

1.

Hello Ed,

Are you able to answer a question related to an inherited IRA?

Send your questions to [email protected]

Here is the issue. I have inherited an IRA from a deceased brother. It is a modest amount of money, about $25k. I am 55 years old. My brother was a few years younger. My question is this. Must I begin to take an annual distribution immediately or should I wait until after age 59.5? Once I begin to take my distributions, are the minimums determined by my age or my deceased brother's age? And lastly, is there a penalty for distributions before I turn 59.5.

Thanks for your enlightened guidance.

Paul

Answer:
Generally you MUST begin taking required distributions from an IRA that is inherited from someone other than your spouse beginning in the year after the death of the account owner. You use your single life expectancy using your age as of the end of the year. This option is often called a stretch IRA. There is never a penalty when taking distributions from an inherited IRA regardless of your age.

You have a second option on how to take the money from the inherited IRA. You can choose the 5-year rule where the funds must be distributed by December 31 of the 5th year after your brother died. Assuming he died in 2012, the deadline would be 12/31/17. During this 5-year period, you can take the money out however you’d like. There is no penalty as long as the account is emptied by the end of the fifth year.


2.

I have an IRA worth $130,000 with $2,000 in basis, and this IRA does not receive contributions. I also have a much larger SEP that receives regular contributions. Can I move $128,000 of IRA into the SEP and just yank the $2,000 IRA balance without tax consequences?

Rex

Answer:
Whether you can move non-SEP money into your SEP depends on the custodian. The IRS allows it, but some custodians insist on keeping SEP money separate from other IRA funds.

You cannot just take the $2,000 basis tax-free because of the pro-rata tax rule that applies to IRAs. Basically, you or your CPA must add together the balances of all your IRAs, including any SEP and SIMPLE IRAs. Then,
you take all your basis and divide it by the total of all the balances in all your IRAs. The percentage you get is the percentage of your distributions for the year that are income tax free. This formula is found in IRS Form 8606. 

-By Joe Cicchinelli and Jared Trexler

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