Backdoor Roth Contributions and the Pro Rata Rule

School of Saving and Investing

The word pro rata as it appears in the dictionary implying the article is focused on the pro rata rule for retirement contributions.

Roth assets can help investors add additional diversification to their retirement plans and may provide tax benefits in the long term. Currently, high earners are prevented from contributing directly to a Roth IRA because of income limits. However, the backdoor Roth IRA method allows these investors to add money to a Roth IRA.

This strategy has been in the news lately as new legislation proposed by House Democrats seeks to end backdoor Roth contributions for top earners. The proposed legislation would prevent some backdoor Roth IRA contributions, but the majority of investors would still be able to implement this strategy if the legislation passes.

While the backdoor Roth IRA method allows high earners to enjoy the benefits of adding Roth assets to their retirement plan, the ‘Pro Rata Rule’ can make this process more difficult. This article will provide an overview of backdoor Roth IRA contributions and discuss how the Pro Rata rule effects investors’ ability to implement that strategy.

What is a Roth IRA and who can contribute?

A Roth IRA is a type of Individual Retirement Arrangement [IRA] that is funded with post-tax dollars. An IRA is a type of tax-advantaged investment vehicle open to individuals saving for retirement. IRAs are not sponsored by employers and are not tied to an individual’s employer like 401(k)s. Anyone with income is able to save money for retirement through an IRA.

Roth IRAs are unique because they are funded with after-tax dollars. Since contributions are made after taxes are paid, no additional taxes are due when the funds are withdrawn during retirement as long as the account holder is age 59 ½ and has maintained a Roth IRA for at least 5 years. Roth IRAs have traditionally benefitted those who are in a lower tax bracket at the time of contribution than they expect to pay during retirement and/or investors who have a long time to save before retirement, allowing their funds to grow tax-free. However, others may also benefit from a Roth IRA even if they don’t fit into one of those categories.

In 2021, individuals can contribute $6,000 to their IRAs per year. This includes both Traditional and Roth IRAs. Unlike Traditional IRAs, Roth IRAs have income limits.

In 2021, an investor who files as single or head of household can contribute the maximum amount to a Roth IRA if their Modified Adjusted Gross Income [MAGI] is below $125,000. If MAGI is between $126,000 and $140,000, they may be able to make a partial contribution.

Individual filers with incomes over $140,000 cannot contribute directly to a Roth IRA. For those filing joint tax returns, the income limits increase to $198,000 for a full contribution, between $199,000 and $207,000 for a partial contribution, and $208,000 as the limit for making any contribution directly to a Roth IRA.

Backdoor Roth IRA Contributions

If your income is above the thresholds, you may still be able to add money to a Roth IRA through the backdoor method. This method involves making a nondeductible contribution to a Traditional IRA and then transferring, or converting, those funds to a Roth IRA. This is typically done in the same year. If the funds in a Traditional IRA earn any income, or increase in value, then the earnings are taxable when the conversion occurs.

Backdoor Roth IRA contributions can help high earners diversify their retirement holdings but there are some considerations. The most common stumbling block for investors seeking to employ this strategy is the Pro Rata rule.

The Pro Rata Rule

The Pro Rata Rule states that you cannot choose which Traditional IRA contributions to convert to a Roth IRA. If you do not have any Traditional IRA holdings, then this rule will not affect your ability to make backdoor Roth contributions. However, if you maintain a Traditional IRA with pre-tax funds, making backdoor Roth contributions becomes more difficult.

If you maintain a Traditional IRA and you have made deductible contributions in the past, or you have rolled over pre-tax funds from an employer sponsored plan, you cannot make a non-deductible contribution to your Traditional IRA and then choose to convert only those funds to a Roth IRA.

The Pro Rata rule designates that conversions must be done proportionally. So, any conversion would include a proportional mix of pre-tax and after-tax funds. The pre-tax portion of the conversion, and any earnings on the after-tax portion, are taxable in the year that you make the conversion to Roth.

Because the Pro Rata rule designates that conversions are proportional, you also can’t choose to move funds invested in a fund that has a loss to avoid paying tax on the earnings portion. If you maintain multiple Traditional IRA accounts, the taxable portion of a conversion is determined based on the holdings and earnings of all of your accounts – prorated to the amount you are converting. However, pre-tax 401ks are not included in the Pro Rata calculation.

In short, the Pro Rata rule makes it impossible to make a true backdoor Roth IRA contribution if you also have Traditional IRA assets. While you can still make nondeductible contributions to a Traditional IRA and process conversions to Roth, at least a portion of the conversion will be taxable if you maintain both types of IRAs.

Is a Backdoor Roth IRA right for you?

There are many factors to consider when determining if a backdoor contribution strategy may be beneficial in your situation. Some of these include your current tax rate, your projected tax rate during retirement, and any existing Traditional IRA accounts. Your risk tolerance and the projected earnings of your retirement accounts are also factors to be carefully considered.

If you have a high income and are considering backdoor Roth IRA contributions to diversify your retirement portfolio, contact an experienced financial advisor to determine if this strategy is right for you.

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