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November 2017

Calculating the Pro-Rata Rule in 5 Easy Steps

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.

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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.

For professional assistance with proactive tax planning for your retirement accounts, make sure to contact us. Click here to contact the office nearest you. 

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