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What is the pro-rata rule?
The pro-rata rule is the formula used to determine how much of a distribution is taxable when the account owner holds both after-tax and pre-tax dollars in their IRA(s). For the purposes of the pro-rata rule, the IRS looks at all your SEP, SIMPLE, and Traditional IRAs as if they were one. Even if you have been making after-tax contributions to a separate account for years, and there have been no earnings, you cannot isolate your after-tax amounts and must take your other IRAs into consideration.
If you hold both pre-tax and after-tax money in your IRA, you’ve likely heard of the pro-rata rule. It’s important to understand how this rule is calculated and how it can impact your retirement funds. In simple terms, the pro-rata rule is used to determine how much of a distribution is taxable when you have a combination of both pre-tax and after-tax dollars in your account.
As you proactively plan for retirement, understanding the tax implications of your various accounts can be key to maximizing your savings. Using the pro-rata rule to help determine the tax on your distributions can give you a better idea of how much money you’ll owe Uncle Samin retirement.
Here's five steps you can use to calculate the pro-rata rule:
#1 - Total up all of your IRAs. Calculate the total balance of all of your IRAs. Include the balanc-es from each of your IRA accounts, including SEP IRAs and SIMPLE IRAs. Roth IRA balances and balances from any non-IRA based company plans are NOT included for this purpose.
#2 - Total up all after-tax dollars in IRAs. Calculate the total balance of all after-tax dollars in all of your IRAs. After-tax dollars are either non-deductible contributions made directly to an IRA or rollovers of after-tax dollars from a company plan. If this is not the first year you have had after-tax dollars in your IRA, you should be able to find the previous year’s after-tax total on IRS Form 8606.
#3 - Calculate your percentage of after-tax dollars. Divide your after-tax IRA dollars (step 2) by your total IRA balance (step 1). If you have $20,000 of after-tax dollars in all your IRAs and the total balance of all your IRAs is $100,000, your percentage of after-tax dollars is 20% ($20,000/$100,000 = 20%).
#4 - Determine the taxable amount of your distribution. Take the total of all your distributions and multiply it by the percentage you have arrived at in step #3. This is the total amount of the distribution that is tax free. If, in our example, a distribution of $10,000 was made, the tax-free portion would be $2,000 (20% x $10,000 = $2,000). The remaining portion of the distribution ($8,000) would be taxable at ordinary rates.
#5 - Exception for rollovers to a company plan or charitable rollovers. Under the Tax Code, only pre-tax dollars can be rolled from an IRA into a company plan. If you are making a rollover from your IRA to a company plan, disregard the pro-rata rule altogether. Just be careful not to roll over more than the total amount of pre-tax dollars in all your IRAs. Qualified charitable distributions (QCDs) from IRAs also disregard the pro-rata rule.
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