The 3 Exceptions To The Pro-Rata Rule That You Need To Know

The pro-rata rule is an essential concept for IRA owners, especially those with after-tax contributions. While most IRA distributions are subject to this rule, there are key exceptions that can significantly reduce your tax liability. Below, we break down the pro-rata rule, explain the formula, and highlight three exceptions you should know to optimize your retirement strategy.

Understanding the Pro-Rata Rule

Most IRA distributions are taxable, but things get complex if you’ve made nondeductible contributions or rolled over after-tax funds into your IRA. Here’s how the pro-rata rule works:

The Pro-Rata Formula

The 3 Key Exceptions to the Pro-Rata Rule

While the pro-rata rule applies to most distributions, these three exceptions allow you to bypass it and reduce your tax bill:

1. Rollovers to Company Plans
   • You can roll over taxable IRA funds to an employer-sponsored retirement plan, such as a 401(k), if the plan permits it.
2. Qualified Charitable Distributions (QCDs)
   • If you’re aged 70½ or older, you can transfer up to $100,000 annually from your IRA directly to a qualified charity, tax-free.
3. Qualified HSA Funding Distributions (QHFDs)
   • Once in your lifetime, you can make a tax-free transfer from your IRA to your Health Savings Account (HSA), up to your annual HSA contribution limit.

Each exception applies only to the taxable portion of your IRA, leaving after-tax funds untouched.

Strategy to Reduce Taxes

Using these exceptions strategically can lower the taxable portion of your IRA distributions. Here’s how:

• By removing taxable funds, the percentage of after-tax funds in your IRA increases.
• Future distributions or conversions will have a smaller taxable portion, reducing your overall tax bill.

Consult with a tax or financial advisor to determine if these strategies align with your financial goals.

Source:
By Sarah Brenner, JD
Director of Retirement Education
Ed Slott and Company, LLC

Copyright © 2022, Ed Slott and Company, LLC Reprinted from The Slott Report, 03/30/22, with permission. https://www.irahelp.com/slottreport/3-exceptions-pro-rata-rule-you-need-know, Ed Slott and Company, LLC takes no responsibility for the current accuracy of this article. Chris Cordoba, founder of California Retirement Advisors, is a member of Ed Slott's Master Elite IRA Advisor Group.

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