Financial Planning, Millennials

Why You Need To Know About The Pro Rate Rule (If You Are Doing The Backdoor ROTH IRA)

The Backdoor ROTH is one of the most commonly used strategies out there. Over the years, I have heard so many people say “I make too much money to do a ROTH IRA.” And while this is true, there is a loophole, it’s called the backdoor ROTH. Many people today know about it, but many do not understand all the rules and what can trick them up.

Before we go into the pro rata rule, let me bring you up to speed on ROTH IRA’s. ROTH IRA’s allow you to put in after tax dollars (different than traditional IRA’s which are pretax dollars), invest those dollars, then take them out tax free in retirement. That is a really powerful tool to never pay taxes on those dollars again. This tax advantage leads many to want to use a ROTH IRA. The problem is that once you reach $153,000 (single) or $228,000 (married) of income, you are over the income limit to do a ROTH IRA. This is where the backdoor ROTH comes into play. If you are above those income limits, then you can put money into an IRA (but not deduct it) then convert it over to ROTH without causing any tax liability (unless the pro rate rule applies). This is the loophole that allows high income earners to do backdoor Roth’s. Make sure you are working with an accountant to properly report this as well.

What Is The Pro Rata Rule?

The Pro-Rata Rule is used to determine how tax-deferred money should be taxed upon withdrawal. Since a Backdoor Roth conversion involves withdrawing Traditional IRA funds and transferring them to a Roth IRA, the Pro-Rata rule applies. Let me explain this further. When you do a backdoor Roth you have to look at all the pre-tax IRA assets you have (Traditional IRA, SEP IRA, etc.) to figure out how much is taxable. Let’s say you want to do the max backdoor Roth for 2023 at $6,500, but you also have $6,500 in another IRA from an old 401(k). Since this $6,500 was a pre-tax deduction, when doing the backdoor Roth you have to look at what IRA assets are pre-tax vs not. In this example, you have 50% pre-tax and 50% non deductible. This means when you do the backdoor Roth you have to pay tax on 50% of the conversion. You do not want this.

How do you avoid this? To side step the pro rata rule, you want to have no other pre tax IRA money out there. You can either move it into your 401(k) by December 31st in the year you want to do the backdoor Roth (if your plan allows it), or you could pay taxes and convert the whole pre-tax account to Roth. Either of these options would work. The main point is that you do not want to do the backdoor Roth while having other pre-tax IRA money or you will have a tax liability. This is something you need to be aware of!

Let’s do one more example to help you fully understand this idea.

  • Jim Makes $400,000 and wants to do a backdoor Roth
  • Jim has $13,000 in an IRA from an old job
  • Jim is going to max out his backdoor Roth at $6,500
  • Jim has a current 401(k) that allows IRA rollovers
  • If he leaves the IRA where it is and does a backdoor Roth, then 66.7% of the conversion is taxable ($13,00/$19,500) = 65%
  • He does not want to have to pay the tax, so he rolls his IRA into his 401(k) by December 31st so he has no other pre tax IRA money out there. This means he can do the backdoor Roth without causing part to be taxable.

I hope this better helps you understand who qualifies for a Roth IRA, who needs to do a backdoor Roth, why the pro rata rule matters, etc.

Disclaimer: None of this is advice. This is just for educational purposes. Please consult your CPA and financial advisor before making any of these moves.