The Pro Rata Rule Made Simple (And How to Avoid Surprise Taxes)

When conducting Roth conversions as part of your financial strategy, many people unknowingly encounter the pro rata rule, which can result in an unexpected tax bill. In this article, we break down what the pro rata rule is, how it works, and ways you can mitigate the tax impact when conducting Roth conversions.

Executive summary

• The pro rata rule affects Roth conversions when your traditional IRA has both pre-tax and after-tax contributions.

• You can’t convert only after-tax (non-Roth) money to a Roth IRA without including a proportional share of pre-tax funds.

• Pre-tax contributions reduce taxable income now, but you are taxed upon withdrawal; after-tax contributions are taxed upfront, only earnings are taxed later; Roth contributions grow tax-free.

• Rolling pre-tax IRA money into a 401(k) can help isolate after-tax funds for a tax-efficient Roth conversion.

• The rule ensures conversions are taxed fairly, preventing selective avoidance of taxes.

  
  

What Is the Pro Rata Rule?

The pro rata rule is an IRS calculation that requires you to pay taxes proportionally on both pre-tax and after-tax funds whenever you perform a Roth conversion. In other words, you cannot convert only after-tax contributions without including a share of pre-tax money—the IRS ensures that each conversion is taxed fairly.

Who Is Most Affected By The Pro Rata Rule?

If you are coming across the pro rata rule, then I can safely assume a few things

1. Your income phases you out or makes you ineligible for direct Roth contributions

2. You have made pre-tax and after-tax contributions to your traditional IRA

3. You are doing or looking to do a Backdoor Roth IRA strategy

As we’ve discussed in some of our previous content, when you’re conducting a backdoor Roth strategy or Roth conversion, you may unknowingly trigger additional taxes due to the pro rata rule.

Pre-Tax Vs. After-Tax Contributions (And Why It Matters)

When making contributions to your traditional IRA, you can contribute on either a pre-tax or after-tax basis. Money contributed on a pre-tax basis gives you a tax deduction in the year it’s added, lowering your taxable income.

What many people don’t realize is that you can also make after-tax contributions to your traditional IRA. This usually happens when your income phases you out from making pre-tax contributions.

Here’s the difference:

• Pre-tax contributions: You don’t pay taxes up front, but you will when you withdraw.

• After-tax, non-Roth contributions: You pay taxes before the money goes in, but when you withdraw, only the earnings are taxed. Your contributions (basis) are not taxed again since you already paid taxes on them.

• Roth contributions: Like after-tax contributions, the money goes in after taxes, but the advantage is that qualified withdrawals are completely tax-free - both contributions and earnings.

How the Pro Rata Rule Works in a Roth Conversion

When it comes to Roth conversions - that is, moving pre-tax or after-tax, non-Roth money into a Roth IRA - the IRS has specific rules.

This only applies if you have both pre-tax and after-tax contributions in your account. Essentially, the IRS doesn’t want you to convert only the after-tax portion (and avoid taxes forever on the pre-tax side). Instead, they require you to convert proportionally and pay taxes on the pre-tax share.

Example: How the Pro Rata Rule Is Calculated

Let’s say Jim and Terry have $100,000 in a traditional IRA. Half ($50,000) is pre-tax, and half ($50,000) is after-tax, non-Roth. They decide to convert $10,000 to a Roth IRA.

Because their account is split 50/50, the IRS requires them to convert proportionally:

• $5,000 comes from the pre-tax side.

• $5,000 comes from the after-tax side.

They’ll owe taxes on the $5,000 pre-tax portion since those funds haven’t been taxed yet, while the after-tax portion converts tax-free.

The 401(k) Strategy to Avoid the Pro Rata Problem

An important exception: If you have pre-tax money inside a group retirement plan (like a 401k), those assets are not included in the pro rata calculation. Because of this, many clients planning Roth conversions first roll their pre-tax IRA money into their 401 (k) (if their plan allows it). This effectively separates the “chocolate from the vanilla.”

A Simple Analogy: Chocolate and Vanilla

Think of it like this: you want to scoop ice cream into your bowl (your tax-free Roth bucket). The tub of ice cream has chocolate and vanilla swirled together. You only want to scoop vanilla (after-tax money). But the IRS says every scoop has to include both chocolate and vanilla in proportion to what’s in the tub. The only way to get pure vanilla is to separate the chocolate first—by moving pre-tax funds into a 401k.

Conclusion

Whether you’re reading about Roth conversions, considering them, or your advisor has recommended them, the pro rata rule is an important factor to keep in mind. Understanding how it works can help you plan conversions more efficiently and avoid unexpected taxes. Hopefully, this article has given you clear insight to strengthen your knowledge and guide your Roth conversion strategy.

Key Takeaways

• Pro Rata Rule: Converts IRA funds proportionally—pre-tax and after-tax combined.

• Taxes: Only the pre-tax portion of the conversion is taxable; the after-tax portion converts tax-free.

• IRA Contributions: Pre-tax lowers income now; after-tax avoids double taxation; Roth grows tax-free.

• Strategy Tip: Move pre-tax IRA funds to a 401(k) if possible to isolate after-tax money.

• Analogy: Conversion is like scooping swirled ice cream—you must include both flavors unless separated.