Maybe you have an IRA, and you want to withdraw some cash for something fun (even though you know better). You will need to pay income tax on these IRA withdrawals but you may encounter a silver lining. You may have some money inside the IRA on which you have already paid taxes. This could have happened in years when you made an IRA contribution but were not eligible to deduct it (because your income exceeded the deduction threshold for that year). So you have already paid tax on that money. Or perhaps at some point you were involved in a company plan such as a 401k and had made after-tax contributions into that plan. When you left that employer, you rolled over the plan balance into your IRA. Those funds still retain their character as either pre-tax or after-tax money.
When you make IRA withdrawals and the IRA contains both pre-tax and after-tax money, the 'Pro Rata Rule' applies.
The Pro Rata rule requires that IRA withdrawals contain a proportionate amount of both the pre-tax and the after-tax amounts in the account. The after-tax amounts are called 'basis.' In an IRA, basis is the amount of nondeductible contributions made (or rolled over) to the IRA.
Paula has $100,000 in an IRA, $20,000 is the basis (the total of her nondeductible contributions made over the years). She rolls over $200,000 from her former employer's 401k plan to the IRA, of which $10,000 is from after-tax contributions. After the rollover, she'll have $300,000 in her IRA. The basis becomes $30,000 (the $20,000 nondeductible plus the $10,000 of after-tax funds rolled into the IRA = $30,000 basis).
Now Paula wants an IRA withdrawal of $10,000. Of the $10,000, just $9,000 is subject to tax. The Pro Rata Rule requires each IRA withdrawal contain a proportionate amount of both taxable and nontaxable funds. Therefore, the nontaxable amount in the IRA is $30,000 and that is 10% of the total $300,000 IRA balance after the rollover. This means that each withdrawal will be 10% tax-free and 90% taxable.
Another option is to convert Paula's entire $300,000 IRA to a Roth IRA. Then all withdrawals will be tax-free. However, she will have a one time large tax bill. She'll pay tax on $270,000; the $30,000 of basis will transfer tax-free to the Roth IRA. A partial conversion from a tradition to Roth IRA would require the use of the Pro Rata Rule.
Lose a Fortune on Your 401k Rollover
If you do not do any of these correctly:
- Opt for a distribution rather than direct transfer
- Rollover company stock to an IRA
- Choose to rollover to a Roth IRA
- Rollover to your new employer’s 401k
- Rollover post-tax contributions