IRA Strategies: After-Tax Money and the Pro-Rata Rule

If you own an IRA and all your contributions were made with pre-tax funds, your withdrawals will be taxed as ordinary income in the year of the distribution. But if you also made after-tax contributions, determining the taxable amount of your distributions may not be that simple, especially if you have multiple IRAs. In that case, the pro-rata rule must be used to determine the percentage of each distribution that is taxable.

Unfortunately, you can’t take a tax-free withdrawal of just after-tax money, leaving any taxable amounts in the account for later. All the assets in your traditional, SEP, and SIMPLE IRAs must be aggregated, which means they are treated as one pool of money, even if they are held at different financial institutions. The pro-rata rule is sometimes called the “cream in the coffee rule” because once you combine after-tax dollars (“the cream”) with pre-tax dollars (“the coffee”) in one of your IRAs, distributions from any of them will have an inseparable mix of both. (Roth and inherited IRA assets are excluded.)

You should consider the potential impact of the pro-rata rule well before you intend to retire or begin taking any taxable IRA distributions — or undertake a Roth conversion — as there may be worthwhile opportunities to help blunt its impact.

Doing the Math

Here are the steps involved in calculating the taxable portion of an IRA distribution.

Step 1: Total the balance of all IRAs required to be aggregated (SEP, SIMPLE, and traditional IRAs) as of December 31 of the year the distribution was taken.

Step 2: Add the amount of all distributions (and conversions) taken during the same calendar year.

Step 3: Total the after-tax dollars (or basis) in those IRAs. The basis includes nondeductible IRA contributions and/or after-tax 401(k) contributions rolled over to an IRA.

Step 4: Determine the pro-rata percentage of after-tax dollars by dividing the Step 3 amount by the Step 2 amount.

Step 5: Calculate the nontaxable portion of your calendar-year distributions by multiplying the Step 4 percentage by the amount of the distribution. The remainder of the distribution is taxable income.

Let’s say that Peggy, who recently retired, takes distributions totaling $25,000 from her traditional IRA. That account has a balance of $300,000 at the end of the same year, and her after-tax basis in the IRA is $100,000. She also owns a SEP IRA, which has a balance of $200,000 and no after-tax funds, so the basis in that account is zero, and her combined IRA balance is $500,000. Calculating Peggy’s pro-rata percentage of after-tax dollars ($100,000 ÷ $500,000 + $25,000 = .19) determines that 19% of her distribution will be tax-free. Therefore, the nontaxable portion of her calendar-year distributions ($25,000 x .19) is $4,750, and the amount of taxable income is $20,250. This hypothetical example of mathematical principles is used for illustrative purposes only.

Wealth Cache

Assets held in IRAs and defined-contribution plans such as 401(k)s dipped in the first three quarters of 2022 to $19.9 trillion. 

U.S. retirement assets, in trillions

U.S. retirement assets: Q4 2018=$16.7 trillion; Q4 2019=$19.8 trillion; Q4 2020=$22.1 trillion; Q4 2021=$24.9 trillion; Q1 2022=$23.6 trillion; Q2 2022=$21.0 trillion; Q3 2022=$19.9 trillion.

Source: Investment Company Institute, 2022

Isolating the Basis

You may be able to lessen the impact of the pro-rata rule by reducing the amount of pre-tax IRA dollars by year-end. This is called isolating the basis. If you have access to a workplace plan such as a 401(k) and reverse rollovers are permitted, you might consider rolling pre-tax IRA funds into the plan. You could also use pre-tax dollars to make a qualified charitable distribution or a qualified health savings account (HSA) funding distribution, which is a one-time direct transfer from a traditional IRA to an HSA.

The IRA custodian will not calculate the taxable and nontaxable portions of any distribution. It is up to you to track your IRA basis by filing IRS Form 8606 for every year you make after-tax contributions, convert pre-tax assets to a Roth account, or receive a distribution that is subject to the pro-rata rule.

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Matthew Englade

Matt graduated in 2008 from Southeastern Louisiana with a bachelor's degree in business. He started his career in financial services, working as a staff member with Delahaye and Associates, where he eventually became a partner.

In 2022 he formed Englade Insurance and Financial Services, where his primary focus is serving his client’s best interest. “But even if you should suffer for what is right, you are blessed.” 1 Peter 3:14

Matt is a resident of Central, LA and enjoys spending time with his wife, Angela, and three children. He also enjoys coaching middle school basketball and giving back to his local church.

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Jacob is currently a student at Southeastern Louisiana University and is studying in the College of Business as a Marketing Major.

Jacob pursues his career by working with Matt and Angela in their mission to spread financial sustainability with their current and future clients. He also donates his time to the Southeastern's College of Business by participating in numerous career services for the city of Hammond.

Having two younger sisters, Jacob understands the importance of protecting family values and leading a path to a secure future.

Nathan graduated from Texas A&M University Class of 2006 with a degree in Agriculture Leadership & Development. Nathan has been in public service as a firefighter since 2008. In addition he and Katherine have started, operated, purchased, and sold multiple small business’. Through his experiences; Financial Services has been a lifelong pursuit for Nathan and he is excited to be a resource for people like you, your family, and your business.

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Angela graduated from Southeastern Louisiana University with a Bachelor of Science degree in Nursing. She worked as a Labor and Delivery nurse for 14 years. She decided to continue her love for caring for others through helping people obtain financial health and wellness.

She joined Englade Insurance and Financial Services to guide Matt's clients on becoming aware of potential roadblocks and achieve financial peace of mind. In her free time, she enjoys spending time with her family and exercising.

Along with Matthew, she volunteers many hours to local charities to give back to the community.

Eve is happily married to her best friend Rick since 2012. They enjoy recreational trips like hiking and camping, visiting the beaches in the Gulf of Mexico, and trips to Walt Disney World. They are active in their congregation, donating their time and effort to help run the Audio/Visual presentations for services. She is grateful for all God has given her and believes all the glory goes to Him.

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