Dan Moisand| For FLORIDA TODAY
Q. Hi Dan. In your last column you wrote about “… a rather infamous provision dubbed the ‘pro-rata rule.’”One of my IRAs is non-deductible, so I need to know what that is and why it’s infamous. Can you help me with that? — Scott in Rockledge
A. Hi, Scott. When it comes to IRAs and this rule, “infamous” is a good word but I could have gone with “notorious” or a host of others with a similar sentiment too.
The pro-rata rule starts off simple enough. Basically, if there are non-deductible contributions in a traditional IRA (not a Roth IRA), a pro-rata portion of a distribution is considered a return of those non-deductible contributions. Because there was no deduction when the contributions were made, those contributions were made with after-tax funds and not taxed again when distributed.
For example, say you have made a total of $50,000 in non-deductible contributions to an IRA worth $100,000. Since $50,000 divided by $100,000 is one-half, 50% of a distribution is not taxable. If you were to take $10,000 out, $5,000 would be tax-free and $5,000 would be taxable.
As is often the case with tax law, it isn’t quite that simple. One tricky aspect is that the denominator used when calculating the non-taxable portion of a distributions is not based on just the value of the account from which the distribution is taken. It is based on the total value of “… all your traditional, traditional SEP, and traditional SIMPLE IRAs …” as of Dec. 31 of the year in which the distribution is made.
More: MAGI, IRA, tax alphabet soup: What am I missing about deducting contributions?
In the above $10,000 distribution example, if you also owned a second $100,000 to which no non-deductible contributions had been made, only 25% ($50,000/$200,000) of the distribution is tax-free and the remaining $7,500 taxable.
If you rolled $100,000 from a 401(k) plan into an IRA the same year you made the distribution, that is added to the denominator too. That makes just 16.67% ($50,000/$300,000) tax-free and $8,333 taxable. This is true even if the rollover went to a separate IRA and even if the rollover happened after the date of the distribution. Remember, the valuation date is Dec. 31 of the year in which the distribution was taken. Form 8606 walks you through the calculation.
Beyond these potential surprises in the year of distribution, some people find Form 8606 aggravating. In our example, Form 8606 calculates the $8,333 of taxable income but it also records the adjusted amount of non-deductible contributions used in the pro-rata calculation for distributions to be made in future years. In this case, that numerator for distributions in future years would be $48,333. That’s the $50,000 of non-deductible contributions less the $1,667 returned in the $10,000 distribution.
Because the non-taxable portion of distributions are pro-rata percentages of the distributions, there is always some non-deductible amount left every year. The need to file an 8606 only stops when there are no more assets in an IRA. This can become annoying for those less tolerant of the paperwork.
Dan Moisand, CFP® was the 2023 chairman of CFP Board, the organization that grants and administers the CERTIFIED FINANCIAL PLANNER™ designation for the more than 100,000 CFP® professionals in the U.S., a past national President of the Financial Planning Association, and has been featured as one of America’s top financial planners by at least 10 financial planning publications. He can be reached at www.moisandfitzgerald.com or 321-253-5400, ext. 101.
