Do you have after-tax dollars in your IRA? This could be from making nondeductible contributions to your IRA or rolling over after-tax funds from your company plan to your IRA. If so, you will want to know about the pro-rata rule. The pro-rata rule is a rule that almost always determines the taxation of an IRA distribution when the IRA owner has any IRA containing after-tax amounts.
How the Pro-Rata Formula Works
You may have more than one IRA. For example, you may have rolled over your 401(k) with a former employer to an IRA. You may also have an IRA where you make annual deductible contributions, and maybe even an IRA where once a long time ago you made some contributions for which you did not take a deduction. When you are doing the pro-rata formula, you must include all of your traditional IRAs. This would include any SEP or SIMPLE IRAs you might have.
With the pro-rata formula, you take the total year-end balance of all your IRAs and divide that into the total balance of all after-tax amounts in all your IRAs. The resulting percentage is then applied to the distribution to determine the tax-free portion of your distribution. The remaining part of the distribution is taxable. If, for example, after-tax funds represent 30% of the account, then 30% of the distribution would be a tax-free return of basis. The other 70% would be taxable. You cannot separate out any one part of your IRAs and select that part to be your distribution. You cannot take out or convert only the after-tax funds in your IRAs. You must use the pro-rate formula.
There are accounts that you might think should be included in the pro rata formula that the rules specifically exclude. If you have any Roth IRAs, they will not be included for purposes of the pro-rata formula. Roth IRAs have their own special rules for determining the taxation of distributions. Also, excluded are other types of retirement accounts that you might have. For example, your 401(k) with your employer is not part of the pro-rata formula used to determine the taxation of an IRA distribution.
What about IRAs you may have inherited from someone else? Any inherited IRAs you may have are NOT included when you are determining the taxation of one of the IRAs in your name.
Example: Grace inherited an IRA from her aunt. She also has her own IRA to which she has been making nondeductible contributions. When Grace determines the taxation of a distribution from her IRA, the pro-rata formula will not include the funds in the IRA she inherited from her aunt.
Instead, inherited IRAs would be subject to their own pro rata formula based on any basis that the deceased IRA owner may have had in their account before their death. As a beneficiary you can claim the basis and avoid paying taxes again on funds on which the IRA owner already paid taxes.
Do you have after-tax dollars in your IRA? This could be from making nondeductible contributions to your IRA or rolling over after-tax funds from your company plan to your IRA. If so, you will want to know about the pro-rata rule.