After-Tax IRA Contributions and the Pro-Rata Rule

For After-Tax Money in an IRA

It is important to understand the “pro-rata rule” before you take a distribution when you have before-tax and after-tax amounts in any traditional, SEP, and/or SIMPLE IRA (collectively “traditional IRA”).

Amounts in a Roth IRA are not subject to this rule, but some qualified employer retirement plans such as a 401(k) may be, if they allow non-Roth after-tax contributions. Also, after-tax amounts you may have in inherited IRAs, where you are the beneficiary, will also use the pro-rata rule but are not included in the pro-rata calculation for your own traditional IRAs.

The pro-rata rule prevents you from being able to simply distribute or convert only the after-tax amount (basis) or before-tax amount from your IRA. Instead, the pro-rata calculation is used to determine how much of a distribution or conversion is taxable when you have both after-tax and before- tax dollars in any of your traditional IRAs.

Before-tax and after-tax funds in traditional IRAs cannot easily be separated. This is true even if you keep the before-tax amounts in a different traditional IRA from the after-tax amounts, as the values of all traditional IRA(s) are combined for purposes of determining the percentage of any distribution (including Required Minimum Distributions) or conversion that is taxable.

Non-deductible IRA contributions

The pro-rata rule applies to any IRAs where over the years you have made both deductible and non-deductible traditional IRA contributions or have repaid reservist distributions. The ongoing filing of IRS form 8606, to keep track of the basis, is used to report all non-deductible contributions.

Qualified Retirement Plans (QRP)

You may have made both before-tax and after-tax contributions to your qualified employer sponsored retirement plan such as a 401(k), 403(b) or governmental 457(b). These after-tax amounts aren’t the same as amounts contributed to a designated Roth account in your plan. When separating from service, the entire plan balance, including any after-tax funds, can be rolled over to a traditional IRA. Under the pro-rata rule, once you roll over after-tax plan assets to a traditional IRA, you must keep a separate accounting for these amounts on IRS form 8606, which will represent basis in your traditional IRA. Instead, it is generally advisable to roll over after-tax contributions (basis) to a Roth IRA, while all before-tax amounts (including earnings on after-tax contributions) are rolled to a traditional IRA. See Convert QRP After-Tax Amounts below for additional information regarding partial distributions.

Pro-rata calculation

In order to determine the percentage of each IRA distribution that is not taxable, first, total the after-tax dollars in all of your traditional IRAs. After-tax dollars include non-deductible IRA contributions, repaid reservist distributions, or rollovers of after-tax dollars from a QRP (the amounts can be found on your IRS form 8606). Then, divide this amount by the 12/31 balance of all your traditional IRAs combined. Next, multiply that percentage by the amount of all traditional IRA distributions. The calculated amount represents the tax-free portion, and the balance of the traditional IRA distribution is taxable. Form 8606 should be filed if you take a distribution of after-tax amounts, and can be used to complete this calculation. You must also include all distributions including conversions and any outstanding rollovers* in that balance.

Note: Calculations done prior to the end of the distribution year may not reflect the actual tax-free portion. This is because the calculation is based on the 12/31 value of your IRAs.

Pro-rata and Roth conversion

The same pro-rata formula applies when calculating the taxes due on a Roth conversion. However, the pro-rata rule does not apply to Roth IRA distributions. Non-qualified Roth IRA distributions are subject to a different set of rules called ordering rules.

Convert QRP after-tax amounts

You do not have to roll your after-tax non-Roth QRP amounts to a traditional IRA. Instead you could (and probably should) choose to roll them to a Roth IRA as a conversion.

A partial distribution from a QRP must include a proportional share of the before and after-tax amounts in the account. It is important to know that you can allocate the before and after-tax eligible distributions to more than one destination, such as a new employer’s QRP, a traditional IRA, a Roth IRA and/or yourself. This allows you the option to elect a direct rollover of the before-tax basis to a traditional IRA without any tax liability and then roll the after-tax amounts to a Roth IRA as a tax-free conversion. Additionally, you could have the distribution made payable to you and within 60 days decide to convert some or the entire amount to your Roth IRA.

A conversion of after-tax basis to a Roth is not a taxable event. In addition, should you decide to convert those after tax amounts, remember those amounts are not subject to the IRS 10% additional tax for early, pre-59½, distributions when following the Roth distribution ordering rules. This strategy alleviates the blending of the before and after-tax amounts in your traditional IRAs and negates the need for the pro-rata calculation.

Remember

Keep your IRS form 8606 with other essential papers as it is important for your beneficiaries to be aware that your traditional IRAs have after-tax amounts. The pro-rata rule will apply to distributions taken by your beneficiary because your traditional IRAs will still have after-tax amounts in them.