What Is the Pro Rata Rule for Roth Conversion?

The pro rata rule is an Internal Revenue Service (IRS) regulation that determines the tax liability of a Roth IRA conversion. This rule becomes relevant when an individual possesses both pre-tax and after-tax funds within their traditional Individual Retirement Arrangements (IRAs). Its purpose is to prevent individuals from selectively converting only after-tax money to a Roth IRA to avoid income taxes, a strategy often used by high-income earners employing a “backdoor” Roth IRA.

The rule mandates that any conversion from a traditional IRA to a Roth IRA must consist of a proportional mix of pre-tax and after-tax dollars. This means you cannot simply isolate and convert after-tax contributions without also converting a proportionate share of the pre-tax funds and their earnings. The IRS treats all of your non-Roth IRAs as a single entity for this calculation, which can lead to unexpected tax consequences if not anticipated.

When the Pro Rata Rule Applies

The pro rata rule applies when you have both pre-tax and after-tax funds across all your non-Roth IRAs at the time you execute a Roth conversion. Pre-tax funds originate from deductible contributions to a traditional IRA or from rolling over assets from a workplace retirement plan like a 401(k). After-tax funds, or basis, come from nondeductible contributions made to a traditional IRA.

For the pro rata calculation, the IRS requires the aggregation of funds from several types of accounts. All of your traditional IRAs are treated as one single IRA. This aggregation also includes any Simplified Employee Pension (SEP) IRAs and Savings Incentive Match Plan for Employees (SIMPLE) IRAs you may hold. The total value of these accounts on December 31 is used to determine the ratio of pre-tax to after-tax money.

Certain accounts are excluded from this aggregation. Your existing Roth IRA accounts are not included in the calculation because they are already funded with after-tax dollars and have their own tax treatment. Similarly, funds held in current workplace retirement plans, such as 401(k)s or 403(b)s, are not factored into the rule unless they have been rolled over into an IRA. Inherited IRAs are also treated separately and are not combined with your personal IRAs for this calculation.

Calculating the Taxable Portion of a Conversion

First, identify your total basis, which is the sum of all after-tax, nondeductible contributions you have made to all of your traditional, SEP, and SIMPLE IRAs. This figure represents the portion of your IRA funds that has already been taxed and must be tracked annually.

Next, determine the total fair market value of all your aggregated IRAs as of December 31 of the year in which the conversion occurred. This total value includes all contributions, both pre-tax and after-tax, as well as all investment earnings. Any distributions or conversions made during the year are added back to this end-of-year total for the calculation.

You can then calculate the percentage of your total IRA assets that is non-taxable by dividing your total after-tax basis by the total fair market value of all your aggregated IRAs. The resulting percentage represents the proportion of your IRA funds that can be converted to a Roth IRA without incurring additional income tax.

To find the tax-free portion of your specific conversion, you multiply the amount you converted by this non-taxable percentage. The remaining portion of the converted amount is considered a distribution of pre-tax funds and earnings. This amount is taxable and must be reported as ordinary income on your tax return for the year of the conversion.

For a practical example, assume an individual has $10,000 in after-tax basis from nondeductible contributions. The total value of all their traditional, SEP, and SIMPLE IRAs on December 31 is $100,000. In this scenario, the non-taxable percentage is 10% ($10,000 basis / $100,000 total value). If this person decides to convert $20,000 to a Roth IRA during the year, only $2,000 of that conversion would be tax-free, and the remaining $18,000 would be considered taxable income.

The Role of IRS Form 8606

IRS Form 8606, Nondeductible IRAs, is the primary tool for reporting and calculating the tax implications of the pro rata rule. This form must be filed with your federal income tax return for any year you make a nondeductible contribution to a traditional IRA, take a distribution from an IRA that has a basis, or complete a Roth conversion from an IRA containing both pre-tax and after-tax funds.

Part I of the form is used to track your basis in traditional IRAs. This is where you report any new nondeductible contributions for the tax year. It also requires you to input your total basis from all prior years, which can be found on the last Form 8606 you filed. Maintaining accurate records of these forms from year to year is important.

Part II of Form 8606 is where the pro rata calculation for Roth conversions takes place. The form guides you through entering the amount converted, your total IRA basis, and the fair market value of your IRAs as of December 31. The form then calculates the taxable portion of your conversion, which is transferred to your Form 1040 to be included in your gross income.

Strategies for Managing the Pro Rata Rule

One common approach to manage the tax impact of the pro rata rule is to perform a reverse rollover. This strategy involves moving the pre-tax funds from your traditional, SEP, or SIMPLE IRAs into a qualified workplace retirement plan, such as a current employer’s 401(k) or 403(b) plan. This is only possible if your employer’s plan documents permit such incoming rollovers from IRAs.

By rolling over only the pre-tax portion, you can effectively isolate the after-tax basis within your traditional IRA. Once the pre-tax funds are no longer in any of your aggregated IRAs, the pro rata calculation changes dramatically. If the only money remaining in your traditional IRA is the after-tax basis, a subsequent conversion of those funds to a Roth IRA can be completed entirely tax-free.

Another strategy is to convert the entire balance of all your traditional, SEP, and SIMPLE IRAs into a Roth IRA in a single tax year. This approach does not avoid the pro rata rule but rather fully resolves it by eliminating all pre-tax IRA funds at once. While this will result in a substantial one-time income tax liability on the entire pre-tax portion of your accounts, it clears the way for future nondeductible contributions and tax-free conversions.