Everything You Need to Know About Pro-Rata Rules

The Internal Revenue Service requires certain distributions from retirement accounts to be done on a pro rata basis, meaning in proportion to the way in which the account contributions were saved. This requirement applies when a participant has non-Roth after-tax money invested in a retirement plan.

Annie Messer, president of member relations at the Pension Resource Institute and a retirement planning and compliance expert, says that in some plans, post-tax and Roth are not synonymous. The rules also differ between employer-sponsored plans, such as 401(k)s and 403(b)s, and Individual Retirement Accounts (IRA).

In 401(k) plans, some participants, especially those with a higher income, will contribute up to the maximum amount ($23,000 for 2024) to their pre-tax account on a pre-tax basis. They may then, if their plan allows, continue to contribute post-tax money to the plan.

Messer says “It isn’t required to max out the pre-tax accounts before contributing after-tax, but this is the most common scenario.” She adds that “after-tax contributions pre-date Roth contributions, which were created in 1997 and permitted in 1998, so many plans have switched to Roth accounts and no longer allow non-Roth after-tax contributions.” Messer describes the ability to send post-tax funds to a pre-tax account in 401(k) plans as “somewhat rare and typically for higher-income people who are able to max out their regular contributions.”

Messer emphasizes that there is a difference between a “designated Roth account vs. after-tax [money] in a pre-tax account.”

When the mixed funds in the pre-tax account are distributed, it must be done in the same proportion as the pre- and post-tax balances in the account, rather than simply being distributed as the participant elects. For example, someone with $23,000 in pre-tax money in a pre-tax account and $7,000 in post-tax, cannot withdraw only the $7,000. Since $7,000 is about 23.3% of $30,000, a $7,000 withdrawal would result in about $1,631 in post-tax money and the rest in pre-tax, which likely would trigger an income tax obligation. Unlike Roth accounts, earnings on 401(k) after-tax contributions are taxable, so only the after-tax contributions are included in the after-tax portion of the balance and the proportional withdrawal.

The IRS phrases it thusly: “If a participant’s account balance in a plan qualified under § 401(a) or in a § 403(b) plan includes both after-tax and pretax amounts, then, under § 72(e)(8), each distribution from the account (other than a distribution that is paid as part of an annuity, which is subject to a different rule) will include a pro rata share of both after-tax and pretax amounts.”

Separately, the IRS says: “You can’t take a distribution of only the after-tax amounts and leave the rest in the plan. Any partial distribution from the plan must include some of the pretax amounts.”

Messer points out this is often referred to as the “cream in the coffee rule,” because once they are mixed, they cannot be separated from each other.

The Case With Rollovers

Rollovers are slightly different. Messer says that in 2014, “the IRS provided guidance that allowed the pre- and post-tax amounts to be sent to different places (traditional and Roth IRAs) as long as the sources were tracked separately in the plan,” which is not always done, Messer says.

In other words, a rollover must still be done on a pro rata basis, but the post-tax can be sent to a Roth IRA and the pre-tax to a traditional IRA.

However, according to the IRS: “earnings associated with after-tax contributions are pretax amounts in your account. Thus, after-tax contributions can be rolled over to a Roth IRA without also including earnings.” This means that only the post-tax basis in the pre-tax account can be rolled over to a Roth IRA, and the earnings must go to a traditional IRA.

This part of the rule matters when it comes to backdoor Roth conversions, which involve the transfer of post-tax money in a pre-tax retirement account to a Roth IRA. This strategy is often used by participants whose income is too high to contribute directly to a Roth IRA.

In traditional IRAs, direct contributions are made with after-tax contributions and the contributions become pre-tax when the individual deducts the contribution on their taxes. If the IRA owner is not eligible to deduct the contribution, based on income and access to a retirement plan at work, then the contribution remains after-tax and creates basis in the account.

When converting pre- and post-tax money in a traditional IRA to a Roth IRA, this must also be done on a pro rata basis and a taxpayer must “take into account your total IRA footprint” when doing so, Messer says, “to determine the ratio of pre- to post-tax.”

This can create a complicated “tax headache,” because that taxpayer will be forced to convert some amount of pre-tax money into the Roth and pay the corresponding tax liability to move the post-tax money to Roth.

Plan Document-Related Issues

The IRS enforces pro rata rules when it comes to post-tax money in pre-tax sources. In addition to that, some plan sponsors have included in their plan documents their own specific rules for how Roth and traditional assets should be drawn down, which can be conflated with IRS regulation.

It is not uncommon for a defined contribution retirement plan to require its participants to withdraw from their traditional (pre-tax) assets first, before taking from their Roth assets. This practice can be helpful to some participants and damaging to others as they plan their retirements.

Summer Conley, a partner with the Faegre Drinker law firm, says this is “something addressed in plan documents,” and “most plans will specify an order for taking out, especially for hardship withdrawals.” Plans with such a provision will normally require that the “pre-tax comes out first,” Conley says.

Provisions like this are intended to help participants. Roth withdrawals are only tax free if at least five years have passed since the first Roth deposit was made by that participant in the plan in question. Requiring participants to postpone Roth distributions can help ensure compliance with this rule.

Additionally, it can be a sound tax strategy to wait before taking Roth distributions. “The longer you leave the Roth in there the more interest it earns,” says Conley, interest that will continue to be tax free, and the longer you take traditional only, the longer that Roth has to grow.

However, this can create headaches and hassle for retirement plan participants and retirees whose needs lend themselves to a different strategy. This can include those who are still working or have a large expense to cover.

Conley urges participants to “read the plan document!” so they can be sure if their plan requires this or not.

Participants can also usually duck this problem by rolling over their traditional and Roth assets into respective IRAs, so the participants can manage the distributions as they prefer.