The Pro-Rata Rule Can Impact Your Roth Conversion Strategy

Tax News You Can Use | For Professional Advisors

 

Anthony Santos Rodriguez, CFP, RICP, Senior Wealth Advisor
Erica Yale, CFP, Wealth Advisor

November 3, 2025

There are a number of powerful benefits of saving for retirement using Roth IRAs. These include:

• Withdrawals, including future growth in value, are excluded from income tax as long as it is withdrawn more than five years later.
• No mandatory distributions while the owner (and often the owner’s spouse) are living.
• If the assets are not used by the owner during life, they can be withdrawn by the named beneficiaries without income tax.

In the last several years, there has been growing interest in the use of Roth IRAs due in particular to today’s historically-low tax rates and the rising national debt. Some commentators are predicting that income tax rates will have to rise in the long term to address growing debt service costs. This elevates the importance and benefits of using a mix of investment accounts with different tax treatments, from fully taxable accounts (personal savings and investments) to tax-deferred (401(k)/IRA) and tax-exempt accounts (Roth 401(k)/Roth IRA). The resulting tax diversification can help manage taxable income in retirement and enhance estate planning and wealth transfer goals.

Roth Conversion As A Tax Diversification Strategy

There are limitations on who can contribute to a Roth IRA directly. For those who have not funded or are ineligible to create a Roth account, one strategy available for improving tax diversification is the Roth conversion. This occurs when assets are transferred out of a tax-deferred account into a tax-exempt account. In a conversion, income tax is paid on the converted amount at the time of conversion (hopefully from assets held outside the IRA in order to maximize the amount converted). The assets then held in the Roth account and their earnings can be withdrawn without paying any tax (assuming the five year rule is met) and are not subject to required minimum distribution (RMD) requirements.

The Pro-Rata Rule

For those that have tax-deferred retirement accounts with a combination of pre-tax and after-tax contributions, there is an added layer of complexity when considering a Roth conversion: It is necessary to comply with the pro-rata rule to achieve the associated tax benefits.

In a traditional IRA containing both pre-tax and after-tax contributions, individuals are not allowed to solely convert the after-tax portion of the assets. The total converted amount must include both pre-tax and after-tax portions. The pro-rata rule determines the ratio that should be applied to calculate the size of these portions. The portion converted that is made up of pre-tax contributions and earnings is taxed at the owner’s ordinary income tax rate. Only the portion that is made up of after-tax contributions is non-taxable.

Application Of The Pro-Rata Rule

The calculation determining the non-taxable portion is the same for both a Roth conversion and a distribution from a traditional IRA.

EXAMPLE:

✓ IRA market value: $750,000
✓ After-tax contributions: $120,000
✓ Conversion amount: $100,000

1. Calculate the after-tax percentage:
   • Total after-tax basis / Total traditional IRA balance
   • $120,000 / $750,000 = 16%
2. Determine the amount of the conversion that is tax-free:
   • $100,000 (conversion amount) x 16% = $16,000
3. Determine the taxable amount of the conversion:
   • $100,000 (conversion amount) - $16,000 (tax-free portion) = $84,000 (taxable portion)

Assuming this individual’s marginal tax rate is 37%, their federal tax liability on this conversion would be $31,080 ($84,000 x 37%). They may owe additional state taxes based on their state of residence.

It is important to know that all traditional IRA assets held by the taxpayer, including SEP and SIMPLE IRAs, are considered in the application of the pro-rata formula. If there are assets held in more than one traditional IRA account, the combined value of the accounts is considered the total traditional IRA balance in the pro-rata calculation. This is referred to as the “aggregation rule.” Opening a new IRA account and making an after-tax contribution does not avoid the pro-rata rule.

Avoiding The Pro-Rata Rule In An Eligible Plan

For individuals who hold pre-tax and after-tax contributions within an eligible retirement plan such as a 401(k), the owner may roll after-tax contributions to a Roth IRA without including associated earnings, and they may roll over the pre-tax amounts with associated earnings to a traditional IRA.

Both pre-tax and after-tax amounts must be rolled over at the same time in order to avoid the application of the pro-rata rule. An individual would not be able to solely roll over the after-tax portion and leave the remaining pre-tax portion in the plan without being required to include some of the pre-tax amount in the partial distribution or rollover.

Rolling pre-tax traditional IRA balances into a current employer’s retirement plan may allow the employee to avoid the pro-rata rule on future Roth conversions from that plan. Each retirement plan is unique regarding whether transfers into the plan are permitted.

Understand Your Options

There are several factors that affect whether a Roth conversion makes financial sense, including the tax characteristics of all traditional IRA assets held, the expected tax liability upon conversion, and whether other assets are available to pay the associated taxes. A conversion might also impact the individual’s estate tax liability and their broader goals. It is important for an individual to consult with their advisors to review these factors and develop a thoughtful strategy for completing a conversion.