Roth Ladder: The Pro Rata Rule and Taxes

Introduction

Roth ladders are a popular retirement strategy for converting traditional IRAs into Roth IRAs. However, if your traditional IRA contains both deductible and non-deductible contributions, the process can become more complex due to the pro rata rule. In this blog, we will delve into the pro rata rule and its implications for Roth ladders.

Understanding the Pro Rata Rule

The pro rata rule states that when you withdraw money from a traditional IRA, it is considered to come from both deductible and non-deductible contributions proportionally. This means that if you have 20% non-deductible contributions, then 20% of any withdrawal will be considered non-deductible.

Impact on Roth Ladders

When you convert a traditional IRA to a Roth IRA, any non-deductible contributions and any earnings on those contributions are tax-free. However, any deductible contributions and earnings on those contributions are subject to income tax.

The pro rata rule complicates Roth ladders because it makes it difficult to isolate the non-deductible contributions and earnings. When you withdraw money from a traditional IRA to convert to a Roth IRA, the IRS will use the pro rata rule to determine the portion of the withdrawal that is taxable.

Example

Let’s say you have a traditional IRA with $100,000 in total contributions, of which $20,000 is non-deductible. If you withdraw $10,000 to convert to a Roth IRA, the pro rata rule would apply as follows:

20% of the withdrawal ($2,000) would be considered non-deductible and tax-free.
80% of the withdrawal ($8,000) would be considered deductible and subject to income tax.

Implications for Filing Taxes

The pro rata rule can make it more difficult to file taxes accurately. When you convert a traditional IRA to a Roth IRA, you must report the amount of the conversion and identify the portion that is taxable.

If you have a traditional IRA with both deductible and non-deductible contributions, it is important to track the contributions and earnings separately. This will help you accurately determine the taxable portion of any withdrawal.

Avoiding the Pro Rata Rule

There are a few ways to avoid the pro rata rule and simplify Roth ladders:

Make only non-deductible contributions to your traditional IRA. This ensures that all withdrawals will be tax-free when converted to a Roth IRA.
Roll over your deductible contributions to an employer-sponsored retirement plan. This allows you to segregate the deductible contributions from the non-deductible contributions.
Withdraw all deductible contributions before converting to a Roth IRA. This eliminates the pro rata rule because there are no deductible contributions left in the traditional IRA.

Conclusion

The pro rata rule can complicate Roth ladders if you have both deductible and non-deductible contributions in your traditional IRA. By understanding the rule and its implications, you can make informed decisions about your retirement savings. If you have any questions or concerns, it is recommended to consult with a licensed financial advisor.