Pro-Rata Rule

Pro-rata rule is an IRS rule that treats all of a person's traditional IRAs — including SEP and SIMPLE IRAs — as a single combined account when calculating the tax owed on a distribution or Roth conversion. If any portion of that combined balance consists of after-tax, nondeductible contributions, the rule prevents a person from cherry-picking just the after-tax money to withdraw or convert; instead, every dollar taken out is treated as the same proportional blend of pretax and after-tax dollars that exists across all of those accounts combined.

The calculation compares the total after-tax basis across all of a person's traditional, SEP, and SIMPLE IRAs to the total balance across those same accounts, including any earnings. That ratio determines what share of any distribution or conversion is treated as taxable pretax money versus tax-free return of basis. Because the rule aggregates by account type — traditional, SEP, and SIMPLE IRAs together — but not across account types like a 401(k), money still sitting in an active employer plan is left out of the calculation entirely. That distinction is central to the backdoor Roth IRA strategy: someone with a large pretax IRA balance who also makes a small nondeductible IRA contribution can't convert only that new after-tax contribution tax-free, because the pro-rata rule blends it with all their other IRA money. Rolling existing pretax IRA balances into an employer plan that accepts rollovers, where available, removes that money from the pro-rata calculation and can clear the way for a clean backdoor Roth conversion. A person's after-tax IRA basis is tracked on Form 8606, filed with their tax return in any year they make a nondeductible IRA contribution or take a distribution or conversion from an IRA that has basis. Because the pro-rata calculation depends entirely on accurate basis tracking across every account, a missing or incorrect Form 8606 in an earlier year can distort the tax result for years afterward.

A hypothetical example: Sam has $95,000 in pretax traditional IRA money from old 401(k) rollovers, plus a new $5,000 nondeductible contribution to a traditional IRA intended for a backdoor Roth conversion. His combined IRA balance is $100,000, of which $5,000 — 5% — is after-tax basis. When Sam converts that $5,000 to a Roth IRA, the pro-rata rule treats the conversion as 95% pretax and 5% after-tax, so $4,750 is taxable as ordinary income and only $250 converts tax-free — even though Sam intended to convert only his after-tax contribution.

Pros

• Prevents savers from artificially isolating after-tax contributions to sidestep the tax treatment that would otherwise apply to their pretax IRA money.
• Keeps the tax treatment of IRA distributions and conversions consistent and predictable once the underlying balances are known.

Cons

• Significantly complicates the backdoor Roth strategy for anyone who already holds pretax IRA money, since it can't simply be ignored.
• Requires careful, ongoing basis tracking through Form 8606 across every traditional, SEP, and SIMPLE IRA a person owns — a missed or incorrect filing can cause the same money to be taxed twice.
• The aggregation rule is easy to overlook, especially for someone who has old rollover IRAs they've forgotten about alongside a new nondeductible contribution.