The Pro-Rata Rule: How It Impacts Your Backdoor Roth IRA (Explained by Vinaigrette)
- Lei Deng
- 2 minutes ago
- 5 min read
When your income is too high to contribute to a Roth IRA directly, a Backdoor Roth can be a powerful workaround. However, pay attention to the Pro-Rata rule to avoid unexpected tax surprises!
Backdoor Roth is a strategy that involves making a non-deductible contribution (a contribution that doesn't give you a tax break in the year it's made) to a Traditional IRA and then converting it to a Roth IRA. This way, you can utilize Roth IRA accounts and enjoy tax-free growth and qualified withdrawals in the future, even when your income disqualifies you from directly contributing to a Roth IRA.
Seems simple enough, right? Not quite, because of something called the Pro-Rata Rule. The Pro-Rata rule is a trickier concept to wrap your head around, so today, I'll use an everyday item, balsamic vinaigrette, to help you better understand exactly how it works.
Want to know more about Backdoor Roth before diving into the Pro-Rata Rule? Read this article first:
What Is The Pro-Rata Rule?
The Pro-Rata rule applies when you have a mix of pre-tax and after-tax money across all of your IRAs.
Pre-tax money is the portion you have received a tax break on in the year of contribution.
After-tax money is the portion you haven't received a tax break on in the year of contribution, likely due to income limits.
Beyond your Individual IRA, the IRS also counts in your balance in SEP IRAs and SIMPLE IRAs. This is a common area of oversight that catches people by surprise after they attempt a Backdoor Roth.
If you have a mixture of both, ideally, you would want to select the portion in your IRA that you already paid tax on (after-tax) when you roll your funds from a Traditional IRA to a Roth IRA. However, the IRS doesn’t allow you to select just the after-tax (non-deductible) contributions. Instead, the IRS views all your IRAs as one combined account. Any Roth conversion you make must include a proportionate amount of both pre-tax and after-tax dollars based on your entire IRA balance.
In simple terms, every conversion pulls from both types of dollars based on their shares within your total IRA assets.
Understanding Pro-Rata Rule through Balsamic Vinaigrette
Here’s where salad dressing helps. Picture your IRA like a bottle of balsamic vinaigrette:
Olive oil represents your after-tax (non-deductible) contributions.
Balsamic vinegar represents your pre-tax (deductible) contributions and any earnings.
When you pour olive oil and balsamic vinegar in, they go in the same jar (Traditional IRA). However, once you shake the jar, the oil and vinegar blend. When your ingredients turn into balsamic vinaigrette, you can’t simply pour out the olive oil by itself; it always comes out mixed with some vinegar.
The IRS treats your Roth conversions the same way. No matter how hard you try to separate it, every dollar you convert includes a portion of both pre-tax and after-tax money.
A Simple Backdoor Roth Example
This year, you want to make a Backdoor Roth contribution because your income exceeded the traditional IRA tax deduction limit. You went through the steps to do a Backdoor Roth.
Step 1: You contributed $7,000 into your traditional IRA. This is after-tax money.
Because you already have $63,000 in pre-tax money in your traditional IRA from years of contributions before, now you have this in your traditional IRA account:
$63,000 in pre-tax IRA money
$7,000 in non-deductible after-tax contributions
Your total IRA balance is $70,000, with 90% pre-tax money and 10% after-tax money. That means every single dollar in your IRA is made up of 90 cents of pre-tax money and 10 cents of after-tax money, like the balsamic vinaigrette, perfectly blended.
Step 2: Now you convert the $7,000 into your Roth IRA. Instead of $7,000 of clean, all after-tax money, the IRS thinks this $7,000 is made up of $6,300 of pre-tax money that it hasn't taxed you on, along with $700 that you already paid tax on.
On paper, your Backdoor Roth is done like anyone else's. However, when you do your tax returns, you might be surprised to find that, in addition to the tax on the $7,000 that you contributed to a traditional IRA, you are also liable for the tax on the $6,300 of pre-tax money in the conversion as well.
Isn't It Double Taxation?
No, it's not exactly double taxation.
After you pay the tax on the $6,300 pre-tax money, the whole conversion of $7,000 will live in your Roth IRA and function exactly like your Roth IRA. Instead of all after-tax $7,000 moving into your Roth IRA, you would still have $6,300 of after-tax money living in your traditional IRA, which will be factored into future conversions or withdrawals.
To avoid complicating things further, make sure that your after-tax (non-deductible) contributions are tracked by filing IRS Form 8606 each year. This form keeps a record of your basis (the money you’ve already paid taxes on) so you’re not taxed again on it during a conversion or withdrawal.
Want to do Backdoor Roth but have a Pre-Rax IRA balance?
The Pro-Rata Rule can’t be avoided once you have both pre-tax and after-tax IRA money in the mix, but you do have options to manage it:
Option 1: Roll Pre-Tax IRA Funds Into a 401(k)
Many 401(k) plans allow you to roll in pre-tax IRA funds. When you do this, you move your pre-tax balances out of your IRAs and into your 401(k). This leaves only the non-deductible (after-tax) contributions in your IRA, giving you a "clean bowl" for future Backdoor Roth conversions. This way, no mixed tax status in your IRA, no problem.
Important: The IRS calculates the Pro-Rata Rule based on your total IRA balances as of December 31st each year. Make sure rollovers are completed before year-end for a clean conversion.
Option 2: Accept the Tax Hit
If your pre-tax IRA balance is small or you’re in a low tax bracket, it may make sense to simply convert and pay tax on the pre-tax portion.
Option 3: Consider Roth Conversion on All IRA Balance
If your pre-tax IRA balance is small, then you can consider rolling all IRA balances into your Roth IRA and accepting the tax for the current year. This allows you to fully transition into Roth going forward.
Option 4: Reconsider the Strategy
If you have significant pre-tax IRA balances and no 401(k) rollover option, the Backdoor Roth may not be the best fit right now. Other tax-efficient savings strategies may make more sense.
The Bottom Line
The Pro-Rata Rule is a critical consideration when using the Backdoor Roth strategy. The IRS doesn’t allow you to pick and choose what portion of your IRA to convert. All your IRAs are treated as one blended account, just like a bottle of vinaigrette. Every Roth conversion you make pulls proportionately from both your pre-tax and after-tax dollars.
Before you execute a Backdoor Roth, review your entire IRA balance, understand how the Pro-Rata Rule applies, and plan accordingly. Of course, you can always reach out to me if you need any help.