The “pro-rata rule” and IRA conversions.

Are you contemplating funding a non-deferred IRA and then effecting a Roth conversion in 2014 because your income level exceeds the phase-outs for funding eligibility?  If so, you may want to pay attention to the pro-rata rule before you take the leap.

Under this rule, outlined in IRS publication 8606, a portion of your conversion will be treated as taxable based on the ratio of taxable to non-taxable IRA assets.  Essentially, the balance in your SEPs, SIMPLEs, deferred traditional and Rollover IRA accounts are taken into consideration which results in a portion of the conversion being taxable based on the ratio of deferred to non-qualified contributions.

For example, an investor with no prior non-taxable contributions and a  12/31/2013 balance of $100,000.00 in a rollover with Fidelity who would like to contribute $5,500.00 to a non-qualified IRA then effect a conversion will have the following results:

1)      Establish the basis:  Prior year non-taxable contributions plus the contribution


2)      Sum of total pre-tax retirement accounts (traditional, Rollover, SEP, and SIMPLE) on December 31 of the prior year end plus the amount converted.

$100,000.00 + $5,500.00

3)      Calculate the ratio for the pro-rata rule by dividing the non-deductible contribution by the sum of line 3

$5,500.00/$105,500.00 = 0.550

4)      Apply the ratio to the amount converted to determine the non-taxable portion of the contribution.

$5,500.00 * .0550 = $302.50

5)      The balance of the contribution is added to the basis for the next calendar year and run the numbers again (if another non-taxable contribution is created).

$5197.5 + next year’s non-taxable contribution

A few options exist for investors with pre-tax assets:

1)      Roll-up your rollover into your new employer’s sponsored plan.

Not all employers will accept Roll-ups, and much of this will depend on who their Third-Party Administrator (TPA) is.  You can contact your TPA to determine if this makes sense.

2)      Convert all of your pre-tax accounts into a Roth and address the additional income.

This may be extremely expensive and ultimately defeat the purpose of tax deferred investing in the first place.

3)      Maintain your pre-tax assets, and fund a non-deductible IRA contribution.

4)      Do nothing.

As with every decision involving taxes, saving, and investing.  It is imperative to consult your financial advisor and tax professional to ensure you’re staying within the field of play.

This posting does not represent a recommendation or tax advice by Jason Brooks or Indelible Wealth Group.