Does the Pro Rata Rule Apply to a 401k?

The pro rata rule is a tax principle applying to distributions from retirement accounts with both pre-tax and after-tax money. It ensures a portion of every distribution or conversion is treated as taxable income, proportional to the ratio of pre-tax to total funds. This article clarifies the pro rata rule’s application, especially concerning 401(k) rollovers and conversions, for effective tax planning.

Understanding the Pro Rata Rule

The pro rata rule primarily applies to Individual Retirement Arrangements (IRAs), dictating the tax treatment of distributions or conversions from accounts holding both pre-tax and after-tax funds. In an IRA, “basis” refers to non-deductible, after-tax contributions that have already been taxed. The Internal Revenue Service (IRS) employs an “aggregation rule” for pro rata calculations. This rule mandates that all Traditional, SEP, and SIMPLE IRAs owned by an individual are treated as a single, combined IRA, regardless of how many separate accounts are held.

For example, an individual has $90,000 in a pre-tax Traditional IRA and $10,000 in a separate Traditional IRA from non-deductible contributions (basis). If they convert $5,000 from the after-tax IRA to a Roth IRA, the pro rata rule applies. The total IRA value is $100,000, with $10,000 (10%) being after-tax. Thus, $500 (10% of $5,000) is a tax-free return of basis, and $4,500 is taxable. This rule prevents individuals from selectively converting only their non-deductible contributions to avoid taxation.

Taxation of 401(k) Distributions

The pro rata rule does not directly govern distributions from a 401(k) plan. 401(k) plans maintain internal accounting to distinguish between contribution types and their earnings. This tracking determines the tax treatment upon distribution.

Pre-tax 401(k) contributions and their earnings are fully taxable as ordinary income upon distribution in retirement. Qualified distributions from a Roth 401(k), including contributions and earnings, are typically tax-free because contributions were made with after-tax dollars. For after-tax 401(k) contributions, the original contributions are tax-free, but any earnings are subject to ordinary income tax upon withdrawal. Plan administrators allocate taxable and non-taxable portions of 401(k) distributions based on plan rules, not the IRA pro rata rule. Some 401(k) plans allow in-plan Roth conversions, where pre-tax or after-tax funds convert to a Roth account within the same plan. The 401(k) plan manages the taxable portion of these conversions, typically pre-tax amounts and earnings, without applying the IRA pro rata rule.

Pro Rata Rule’s Relevance to 401(k) Rollovers and Conversions

The pro rata rule becomes a factor for 401(k) funds when rolled into an Individual Retirement Arrangement (IRA), particularly if Roth conversions are planned from that IRA. Its impact stems from commingling different fund types within IRAs.

When pre-tax 401(k) funds are rolled into a Traditional IRA that already contains non-deductible (after-tax) contributions, any future Roth conversion from that IRA will be subject to the pro rata rule. For instance, if an individual rolls over a $50,000 pre-tax 401(k) into a Traditional IRA holding $10,000 of non-deductible contributions, the entire $60,000 balance is considered when determining the taxable portion of any Roth conversion.

A common strategy involves rolling after-tax 401(k) contributions directly to a Roth IRA, known as a “Mega Backdoor Roth.” While the after-tax contributions are generally tax-free when rolled to a Roth IRA, any earnings on them are pre-tax and must go to a Traditional IRA. If these earnings are then converted to a Roth IRA, they become taxable. The pro rata rule applies if these Traditional IRA funds commingle with other pre-tax IRA money before conversion.

Rolling both pre-tax and after-tax 401(k) money into a single Traditional IRA creates a tax basis within that IRA. This subjects any subsequent Roth conversions from any Traditional IRA to the pro rata rule. The “pro rata trap” impacts Roth conversions from IRAs holding a mix of pre-tax and after-tax money, regardless of the original source. To avoid this, some individuals roll pre-tax IRA funds into an employer-sponsored plan that accepts rollovers, leaving only after-tax money in their IRAs for a cleaner Roth conversion.

Reporting Non-Deductible Contributions and Conversions

Accurate reporting of non-deductible IRA contributions and Roth conversions is important for tax compliance, especially with the pro rata rule. This is primarily done using IRS Form 8606, “Nondeductible IRAs.”

Form 8606 tracks the basis, or after-tax contributions, in all Traditional, SEP, and SIMPLE IRAs. This tracking prevents double taxation on amounts already subject to income tax.

• Part I reports non-deductible contributions made to a Traditional IRA for the tax year.
• Part II calculates the taxable portion of Roth conversions from Traditional, SEP, or SIMPLE IRAs, applying the pro rata rule based on aggregated IRA balances.
• Part III addresses distributions from Roth IRAs, helping determine if any portion is taxable, such as non-qualified distributions.

File Form 8606 annually, even in years without a distribution or conversion, to maintain an accurate record of basis.