Here’s how to pay less tax on your IRA

proportional rule

proportional rule

Roth Individual Retirement Accounts (IRAs) can be a powerful tool in your retirement plan, so it may come as no surprise that Roth conversions are a popular method of circumventing Roth IRA income limits. However, many retirement savers are unaware that the conversion of Roth could trigger a complex tax bill due to a little-known regulation called the Pro-Rata rule. Here’s a guide on how it works.

A financial advisor can help you plan for retirement and help you determine if a Roth conversion is the best option for you. Find a qualified advisor today.

What is a Roth IRA?

Roth IRAs are tax leveraged retirement accounts that allow you to increase your post-tax money without paying more in retirement. As a result, they are subject to specific rules governing tax-free withdrawals.

Because withdrawals can be exempt from taxes and penalties, the Roth IRA limits contributions to winners who make less than a certain income. In 2022, the limit for married couples who file joint taxes is $ 214,000.

What is Backdoor Roth or Roth IRA conversion?

High-income earners who want to benefit from tax-exempt withdrawals often turn to Roth transformations as a way to circumvent the strict income limits for Roth contributions, especially since there is no limit to how much you can convert to a Roth IRA. The idea is to take the IRA’s traditional funds, pay taxes on the amount you want to transfer to a Roth account, and then take advantage of tax-free growth until retirement. This transformation is often called a Backdoor Roth contribution.

However, many retirement savers are unaware of this tax consequences that such a process can cause. Roth IRAs are funded with dollars after taxes, so many assume that moving deferred tax money to a Roth IRA means you will pay taxes on the amount that needs to be converted, and that’s it. Unfortunately, this is only true if you have never deposited money without deduction or after taxes in a traditional IRA.

If you’ve ever supplemented your traditional IRA beyond a 401 (k) rollover, your conversion tax bill may be more complicated than you think.

What is the proportional rule?

proportional rule

proportional rule

The proportional rule is used to determine how money should be taxed with deferred withdrawal tax. As the transformation of Backdoor Roth involves withdrawing traditional IRA funds and transferring them to the Roth IRA, the Pro-Rata rule applies.

If you have never contributed post-tax money to a traditional IRA, the total amount you convert to a Roth IRA will be taxed at your normal income tax rate. The process is relatively easy. However, if your traditional IRA contains both pre-tax (deductible) and post-tax (without deduction) contributions, the Pro-Rata rule dictates that your conversion to Roth will be taxed in proportion to your pre- and post-tax rates. To prevent people from circumventing Roth’s income limit and manipulating funds to reduce their tax bill, you are not allowed to choose which funds to convert.

How to calculate your tax rate with Proportional rule ?

Let’s say you have $ 100,000 in a traditional IRA, $ 7,000 of which comes from non-deductible contributions. Because you have already paid $ 7,000 in taxes, the IRS will not require you to pay taxes on that amount twice. Some retirement savers believe that because they have already paid taxes on this amount, they can convert $ 7,000 into a Roth IRA without paying taxes again. However, you cannot legally dictate that your Roth conversion will use only these post-tax funds.

If you want to convert $ 7,000 into a Roth IRA, you will need to calculate how much of your IRA funds are actually taxed. The IRS requires you to include the value of all your non-Roth IRAs as a basis. The formula for tax purposes looks like this:

  • (non-deductible amount) / (total amount of all balances other than Roth IRA) = non-taxable percentage

  • (amount to be converted into Roth IRA) x (non-taxable percentage) = amount of post-tax funds converted into Roth IRA

In other words, 7% of $ 100,000 is not taxable because you have already paid taxes on that $ 7,000. But if you want to convert $ 7,000 into a Roth IRA, the amount actually converted comes from 93% of pre-tax funds and only 7% of post-tax funds. You will have to pay taxes on 93% or 6510 dollars of the converted amount. Similarly, this means that $ 6,510 of the original non-deductible $ 7,000 is still in the traditional IRA, and any future post-tax contributions to your non-Roth IRAs will further complicate your Pro-Rata rate, which will make future withdrawals more confusing than you might think.

Eventually

proportional rule

proportional rule

Backdoor Roth conversions are subject to the Pro-Rata rule, which dictates how non-Roth IRA withdrawals are taxed. Some retirement savers believe they can deposit post-tax money into a traditional IRA and then convert the funds into a Roth IRA as a way to avoid the Roth IRA’s income constraints and benefit from tax-free growth, but the Pro- Rata prevents them from doing so. Instead, the IRS requires taxpayers to calculate their taxable contribution rate and to pay a proportionate amount when withdrawing from deferred tax accounts. This can complicate matters and can lead to an unexpected tax bill for the reckless.

Retirement planning tips

  • Not sure if converting to Roth can help you save more on retirement? For a solid, long-term financial plan, consider talking to a qualified financial advisor. Free SmartAsset tool combines you with up to three financial advisors who serve your area, and you can interview your advisors’ meetings for free to decide which one is best for you. If you are ready to find an advisor who can help you achieve your financial goals, start now.

  • Use SmartAsset for free retirement calculator to get a good first grade how much money you will need to retire.

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