Navigating the Pro Rata Rule when Using a Backdoor Roth IRA
What is a Roth IRA?
There are two ways that you can contribute to an IRA: post-tax and pre-tax.
A Roth IRA allows you to pay taxes on your money now, invest that money, and never have to pay taxes on any of the gains from that investment. Therefore, your contributions are post-tax.
Traditional IRAs on the other hand allow you to defer your taxes today by taking a tax deduction on the amount you invested into your account, invest that money, and then pay taxes on the distributions. These would be pre-tax contributions.
Why should I choose a Roth IRA?
Both the Traditional and the Roth should be looked at in your overall tax strategy. However, many people are of the opinion that it is better to pay the taxes now to decrease your risk of paying more taxes later. Taxes may rise in the future, or you may be in a higher tax bracket later in life. By paying the taxes upfront you are protected from any potential increases.
Why can’t I use the front door?
You can! If you are within the income limitation rules, then you can contribute directly to a Roth IRA. Here is a link to the most up to date IRS guidance on IRA contribution limits.
- If you are a single filer your Modified Adjusted Gross Income (MAGI) must be below $138,000 to contribute the full $6,500 ($7,500 if you are 50 or over) to your IRA.
- If you are married filing jointly your MAGI must be below $218,000 to contribute the full $6,500 ($7,500 if you are 50 or over) per spouse to your IRA.
As you can see if you are a high-income earner, you may not qualify to contribute directly to a Roth IRA. Your options are then to either contribute to a different type of retirement account, or use the Backdoor Roth Strategy.
What is the backdoor?
The backdoor is where you make a post-tax contribution to a Traditional IRA and convert those contributions into a Roth IRA.
As of the writing of this article this is a known, widely used and accepted strategy for getting funds into a Roth IRA. However, it is not as straight forward as contributing directly to your Roth IRA and making a mistake could create unintended negative tax consequences.
One of the most common pitfalls is not properly navigating the Pro-Rata rule also known as The Cream in the Coffee rule.
The Cream in My Coffee?
There are three components to the coffee with cream analogy. 1) the cup 2) the coffee 3) the cream.
The Cup: The cup is the Traditional IRA account type. There are three different accounts that work as a Traditional IRA: the standard Traditional IRA, the SEP IRA, and the SIMPLE IRA. It is important that you realize that for the purposes of the Pro Rata rule the IRS is looking at all three of these accounts as one big cup rather than three separate cups. So, when you contribute to any one of these accounts it will be mixed with contents of the other two.
The Coffee: The coffee is your pre-tax contributions.
The Cream: The cream is your post-tax contributions.
Okay... so what does that mean for me?
What this means is that if you were to have pre-tax contributions in any Traditional IRA accounts and then were to make post-tax contributions all your contributions would now be mixed and you wouldn’t be able to separate them on distribution. Similar to how once you’ve added cream to your coffee you can’t just pour out the cream!
Why is this an issue?
Let’s take an example, you have $45,000 in pre-tax contributions in your Traditional IRA cup. You decide to use the backdoor to add $5,000 to your Roth IRA. So, you add $5,000 post-tax into your Traditional IRA and convert $5,000 of your traditional IRA to a Roth IRA.
You just caused yourself to have to pay taxes on 90% (45,000/50,000) of the $5,000 you converted into your Roth IRA. This is because you added the cream to your coffee it all got mixed and when you went to pour it out just the cream the coffee came out with it.
What could have been done instead?
A solution to this problem it to make sure that there is nothing in your cup when you go to add the cream!
One way to do this would be to rollover all of your Traditional IRAs into a 401k. With these accounts now empty you can be sure that post-tax dollars will not mix with pre-tax dollars when added to your traditional IRA. Then when you convert to a Roth IRA only post-tax dollars will come out.
This all sounds too complicated
It sounds complicated because as with anything having to do with the US tax code… it is! If you’d like help with tax planning and implementation of a Backdoor Roth IRA let us know and we’ll help guide you through.
While we’ve got you here, why not take a look at our CPA services.
The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting, or investment advice. You should consult a qualified legal or tax professional regarding your specific situation.