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What is the pro-rata rule, and how does it impact a Backdoor Roth IRA?

 The pro-rata rule is an IRS rule that determines how taxes are calculated when you convert money from a Traditional IRA to a Roth IRA and you have both pre-tax and after-tax funds across your IRA accounts.

This rule is particularly important when using the Backdoor Roth IRA strategy, which involves:

1. Making a non-deductible (after-tax) contribution to a Traditional IRA.

2. Converting that amount to a Roth IRA.

Many people assume the conversion will be tax-free because the contribution was already taxed. However, the pro-rata rule may cause part of the conversion to be taxable if you have other pre-tax IRA balances.
 

How the Pro-Rata Rule Works

The IRS treats all of your Traditional, SEP, and SIMPLE IRAs as one combined balance when determining how much of a Roth conversion is taxable.

When you convert funds to a Roth IRA, the IRS requires the conversion to include a proportional share of pre-tax and after-tax money from your total IRA balances.

In other words, you cannot choose to convert only the after-tax contribution.Instead, the conversion is taxed based on the ratio of after-tax contributions to total IRA balances.

The calculation is based on the total value of all Traditional, SEP, and SIMPLE IRAs as of December 31 of the conversion year.

Example of the Pro-Rata Rule
Suppose the following situation:

You decide to convert $6,000 to a Roth IRA using the Backdoor Roth strategy.
Because of the pro-rata rule:

•  After-tax portion = $6,000 / $100,000 = 6%

• Pre-tax portion = 94%

When you convert $6,000:

Even though your $6,000 contribution was after-tax, most of the conversion becomes taxable because of the existing pre-tax IRA funds.