Traditional IRAs are, for the most part, funded with pre-tax dollars and grow tax-deferred until the money is withdrawn from the IRA. With that said, it’s possible for after-tax dollars to find their way into Traditional IRAs. When this happens, the IRA is said to contain basis, and while you don’t have to pay tax on the basis again at the time of distribution, you are not permitted to isolate the basis for the purpose of a tax-free distribution or Roth IRA conversion either. Instead, the IRS applies what’s known as the pro-rata rule, which essentially forces you to account for your basis proportionately with each distribution or conversion.
While the pro-rata rule catches many by surprise, it may not only be possible for you to circumvent the pro-rata rule, but you may also be able to convert your basis to a Roth IRA without any additional tax liability.
Before we get into the specifics, let’s cover a few of the common ways you may end up with basis in a Traditional IRA. For starters, your contributions to a Traditional IRA may have been considered non-deductible in years your income exceeded the IRS thresholds for making deductible (pre-tax) contributions. Also, some employer sponsored plans, such as 401(k)s, permit after-tax contributions (entirely different from Roth accounts now offered in employer plans), which may find their way into a Traditional IRA when the employer plan is rolled-over into an IRA. Another possibility, and one I find common among federal employees, is when Civil Service Retirement System participants have transferred their entire Voluntary Contribution account, which is funded with after-tax dollars, to a Traditional IRA.
When you have basis in a Traditional IRA and you take a distribution, or perform a Roth IRA conversion, the pro-rata rule requires you to aggregate all of your Traditional IRAs (including SEP IRAs and SIMPLE IRAs) to determine the percent of the distribution or conversion that will be considered basis, and therefore, tax free. The amount that will be considered basis is the proportion of non-deductible contributions to the total value of all your IRA accounts.
For example, let’s assume John has two IRA accounts – one valued at $25,000 and consisting entirely of after-tax contributions, and the second, consisting of pre-tax contributions and tax-deferred earnings, valued at $75,000. John’s basis represents 25 percent of his total IRA money and the pre-tax money represents the other 75 percent. Regardless of which IRA John decides to take a distribution from (or converts to a Roth IRA), 75 percent of the distribution (or conversion) will be taxable and 25 percent (the pro-rata portion of the basis) will be tax free.
While the pro-rata rule typically applies to all distributions, as well as to any Roth conversion, there is a special rule which permits you to transfer only the pre-tax money in IRA accounts to an eligible retirement plan, including the Thrift Savings Plan. This special rule permits you to isolate, and leave only basis remaining in an IRA account as long as the amount remaining is at least equal to the basis.
Let’s now assume John, from the previous example, owns a TSP account in addition to his two IRAs. Since the TSP permits participants to transfer money from a Traditional IRA into a TSP account, John may transfer the $75,000 in pre-tax money from his IRA accounts to his TSP account, which will leave $25,000 remaining in his IRA consisting entirely of basis. At this point, John may take the $25,000 from his IRA as a tax-free distribution (he’s already paid tax on the money, so the IRS won’t tax it again), or he may wish to convert the basis to a Roth IRA – tax free – and enjoy years of tax-free growth and distributions.
In this example, John had multiple IRAs, but that’s not a requirement for this to work.
Furthermore, if you like the flexibility IRAs provide, you may transfer the money from the TSP back into an IRA. Of course, you’ll need to make sure you understand and follow the TSP distribution rules.
If you have basis in an IRA, you may want to consider this special rule to maximize the potential of this after-tax money. Additional information may be found in IRS Publication 590.