Pro rata rule: how the IRS taxes IRA conversions and withdrawals

The pro rata rule says that when you take money out of a traditional IRA, or convert it to a Roth, you cannot choose to withdraw only the after-tax dollars. The IRS treats all your traditional, SEP and SIMPLE IRAs as one combined account, and every distribution or conversion is taxed in the same proportion as the pre-tax and after-tax money across all of them, measured at the end of the year.

In practice this means a person with a large pre-tax rollover IRA who makes a small non-deductible contribution and converts it will find most of that conversion taxable. The rule is mechanical and predictable once you see the calculation, and there are legitimate ways to plan around it.

Where the rule comes from

Two pieces of the tax code work together.

First, IRC §408(d)(2) requires that, for the purpose of working out the taxable part of a distribution, all of an individual's traditional IRAs are treated as a single contract, all distributions in a year are treated as one distribution, and the value of the IRAs is measured at the close of the calendar year. SEP and SIMPLE IRAs are included because they are traditional IRAs for this purpose.

Second, IRC §72 provides that a distribution is partly a tax-free return of your investment (your "basis") and partly taxable, in proportion. In an IRA, your basis is the total of non-deductible contributions you have made and not yet recovered, plus any after-tax money you rolled in.

The IRS applies the rule through Form 8606, Nondeductible IRAs. You file it for any year you make a non-deductible contribution, take a distribution from a traditional IRA while you have basis, or convert to a Roth.

Which accounts count and which do not

Getting the list right is half the battle.

Included in the calculation	Not included
Traditional IRAs, including rollover IRAs	Roth IRAs
SEP IRAs	401(k), 403(b) and governmental 457(b) plans
SIMPLE IRAs	Inherited IRAs you hold as a beneficiary (these carry their own separate basis)
Rollovers out of an IRA still in transit at year end	Your spouse's IRAs (the rule applies person by person)

The employer plan exclusion is the one that makes planning possible, which I come back to below.

The Form 8606 calculation, step by step

Form 8606 Part I works out the non-taxable share of the year's distributions and conversions. Simplified, it goes like this:

1. Total basis. Add your basis carried forward from earlier years to any non-deductible contributions for the current year.
2. Year-end value. Take the combined value of all your traditional, SEP and SIMPLE IRAs on December 31, plus any outstanding rollovers.
3. Add back what left. Add the distributions you took during the year and the amounts you converted to Roth.
4. Non-taxable percentage. Divide total basis by the figure from step 3.
5. Apply it. Multiply the year's distributions and conversions by that percentage. That portion is tax-free; the rest is taxable income.

Any basis you did not use carries forward to the next year's Form 8606. It is not lost.

A worked example

The figures below are illustrative, chosen to make the arithmetic easy. They are not contribution limits or recommendations; current annual IRS limits change each year, so check them before contributing.

Assume someone has:

• A rollover IRA from an old employer plan worth $180,000, all pre-tax.
• Accumulated IRA basis of $20,000 from several years of non-deductible contributions, sitting in a separate traditional IRA also worth $20,000.

In the current year they convert the $20,000 account to a Roth IRA, expecting it to be tax-free because it was all after-tax money. Assume, for simplicity, the rollover IRA is still worth $180,000 on December 31.

Step	Amount
Total basis	$20,000
December 31 value of all traditional IRAs	$180,000
Plus amount converted during the year	$20,000
Total	$200,000
Non-taxable percentage	$20,000 ÷ $200,000 = 10%
Tax-free part of the $20,000 conversion	$2,000
Taxable part of the conversion	$18,000

Separate accounts made no difference. The IRS looks through them and treats the $200,000 as one pot that is 10% after-tax. Of the $20,000 basis, $2,000 was used and $18,000 carries forward, now attached to the remaining rollover IRA.

The same maths applies to an ordinary withdrawal. If the person had simply taken $20,000 as cash instead of converting, $18,000 would be taxable, and if they were under 59½ the 10% additional tax could apply to the taxable part unless an exception covered it.

Why December 31 is the date that matters

The rule uses your year-end balance, not the balance on the day of the conversion. This cuts both ways.

It helps if you convert early in the year and then, before December 31, move your pre-tax IRA money out of the IRA system (for example, into an employer plan). The year-end value would be close to zero, and the conversion earlier in the year would be almost entirely tax-free.

It hurts if you convert early in the year and then, later in the same year, roll an old 401(k) into a new rollover IRA. That new pre-tax balance is counted on December 31 and pulls the conversion's non-taxable percentage down retroactively. I have seen this happen more than once, usually because the rollover and the conversion were handled by different people who never compared notes.

Since 2018, conversions can no longer be recharacterized back to a traditional IRA, so there is no undo button once the conversion is done.

Planning around the pro rata rule

There are three main approaches, and each has trade-offs.

Roll pre-tax IRA money into an employer plan. Many 401(k) and 403(b) plans accept incoming rollovers from IRAs. The tax code only allows pre-tax amounts to be rolled from an IRA into an employer plan, so doing this leaves the after-tax basis behind in the IRA. You can then convert that basis with little or no tax. Check that your plan accepts roll-ins, compare its investment options and fees with your IRA, and complete the rollover before December 31 of the conversion year. Our 401(k) rollover guide covers the mechanics of moving money between accounts.

Convert everything and pay the tax. If the pre-tax balance is modest, or you are in a low-income year, converting the whole amount may be reasonable. The pro rata rule then does not matter, because everything ends up in the Roth. Our Roth conversion guide explains how to think about the tax cost, and the Roth conversion calculator lets you test illustrative scenarios.

Accept the proportion and plan over several years. Some people convert a slice each year, filling up a lower tax bracket, and let the basis come out gradually. This is slower but spreads the tax.

What does not work is opening a separate IRA to hold the after-tax money. As the example shows, the IRS aggregates the accounts regardless of how many there are.

The backdoor Roth and the pro rata rule

The pro rata rule is best known as the trap in the backdoor Roth IRA. A high earner who cannot contribute directly to a Roth makes a non-deductible traditional IRA contribution and converts it. If they have no other pre-tax IRA money, the conversion is nearly tax-free. If they have a large rollover IRA, most of the conversion is taxable, and the strategy loses much of its appeal unless they first clear out the pre-tax balance.

How the rule works inside employer plans

Employer plans have their own version. When a 401(k) holds both pre-tax and after-tax money, a distribution from the plan generally carries a proportional share of each under IRC §72(e)(8). The difference is that plans are not aggregated with IRAs or with each other.

IRS Notice 2014-54 added a useful allocation rule: when you take a full distribution from a plan and send it to more than one destination at the same time, you can direct the pre-tax portion to a traditional IRA and the after-tax portion to a Roth IRA. That is the mechanism behind the mega backdoor Roth when the plan does not offer in-plan conversions.

Keeping records so you do not pay tax twice

Your basis only protects you if you can prove it. The main risks I see are:

• Not filing Form 8606 in a year you made a non-deductible contribution. Without it, the IRS has no record of your basis, and the IRS can charge a penalty for the missing form. More importantly, you may later pay tax on money that was already taxed.
• Losing the trail after changing preparers or software. Keep copies of every Form 8606 you have filed. If you have gaps, older returns and IRA custodian statements (including Form 5498, which reports contributions) can help you reconstruct the figure.
• Forgetting basis at death. Basis passes to beneficiaries with an inherited IRA. Executors and heirs should ask for the decedent's last Form 8606.

Frequently asked questions

Does the pro rata rule apply to 401(k) balances?

No. The IRA aggregation rule covers traditional, SEP and SIMPLE IRAs only. Money in a 401(k), 403(b) or governmental 457(b) plan is not counted on Form 8606, which is why rolling pre-tax IRA money into an employer plan can isolate after-tax basis.

Can I avoid the pro rata rule by using separate IRAs?

No. For tax purposes, all your traditional, SEP and SIMPLE IRAs are treated as one account, however many custodians or accounts you use. The non-taxable percentage is calculated on the combined total.

Does my spouse's IRA count toward my pro rata calculation?

No. The rule applies to each individual's own IRAs. A spouse's traditional IRA balance does not affect your calculation, even if you file a joint return.

What happens to basis I do not use this year?

It carries forward. Each year's Form 8606 shows the basis remaining, which becomes the starting point for the next year's calculation until it has all been recovered.

This article is general education, not personal tax advice. The pro rata calculation depends on year-end balances and your full filing history, so review your own Form 8606 records, or ask a tax professional, before converting or withdrawing.