Backdoor Roth and the Pro-Rata Snag

Every year, thousands of high-income taxpayers make backdoor Roth contributions. In a nutshell, a backdoor Roth contribution is a loophole that provides a way for high-income earners who would normally be excluded from contributing to Roth accounts to do so. However, as this strategy continues to grow in popularity, there exists a technical snag within the process. This can get complicated, but follow along and make sure you’re doing it right. First, a little context:

The concepts here can get pretty complicated. Don’t hesitate to reach out with any questions!

Terms and concepts:

Roth IRA: This savings account allows for after-tax contributions (you pay tax now), earnings grow tax-deferred, and ALL distributions are tax-free so long as you follow the rules.

Traditional IRA: These are the opposite of Roth IRAs; contributions are tax-free going in, grow tax-deferred, but distributions are taxed coming out.

Roth conversion: Allows traditional IRA funds to be transferred into Roth IRA accounts so long as owners pay taxes on the converted amount.

Until 2010, Roth conversions were limited to workers making less than $100,000 a year. Those making more than $100,000 were out of luck. This limit was in addition to the annual income limit that restricted both Roth and traditional IRA contributions altogether (which still exists). However, in 2010, this income limit for conversions was removed. Shortly thereafter, an interesting tactic emerged. This tactic has since become known as a backdoor Roth contribution.

Backdoor Roth contribution: An after-tax contribution is made to a traditional IRA and is immediately converted to a Roth IRA.

Since then, this strategy has gained significant popularity among high-income earners. Why high-income earners? This is because income limits still exist for folks wanting to make contributions to IRA accounts. For instance, in 2025, a married couple with a modified AGI over $246,000 is prohibited from making standard contributions to an IRA (Roth or otherwise). Now, it’s important to note that these limits still exist and will likely continue to exist. The backdoor Roth tactic simply circumvents these limits; it doesn’t supersede them. Let me explain.

The after-tax contribution rule: Allows anyone to make after-tax contributions to an IRA account (regardless of income).

When we talk about income limit restrictions to contribute to an IRA, what we really mean is restrictions on making pre-tax contributions. That is, typically, contributions to a traditional IRA are deductible from taxable income. This is the most common form of IRA contribution. It results in a current year tax break with ALL distributions in retirement completely taxable as income.

What isn’t as well known is that anyone, regardless of income, can make after-tax contributions to an IRA each year. A worker can earn $1,000,000 in 2025 and still make an after-tax contribution to their IRA. The annual contribution limit still applies ($7,000 in 2025), but anyone can make it so long as they have earned income.

So what’s the difference with after-tax contributions? The difference is that after-tax contributions are not deducted from income the way normal pre-tax contributions are. You may wonder why anyone would make an after-tax contribution to an IRA since they don’t get a tax break. The answer is that after-tax contributions in an IRA still grow tax-deferred just like any other IRA. So, if someone makes a $7,000 after-tax contribution to their IRA, it will grow tax-free until they choose to withdraw it in retirement. The difference is they don’t get a tax break in the contribution year.

Cost basis treatment

We’ve just covered how pre-tax and after-tax contributions are deducted or taxed in the contribution year. However, there is another very important difference.

After-tax contributions create cost basis within the IRA.

When someone makes a normal contribution to an IRA, a tax deduction is made in that year and taxed as income when withdrawn in retirement. However, since after-tax contributions don’t enjoy the same tax-free status in the contribution year, they create a cost basis balance that avoids taxes when withdrawn. Think about it; if taxes are already paid on the contribution, then it would be unfair for taxes to be charged on that same amount in retirement. This would amount to double taxation, which is illegal (unless we’re talking about corporate dividends or estate taxes… but that’s a rant for another time).

For a practical example, imagine a high earner contributes $5,000 after-tax to their IRA in 2025. This would create a $5,000 cost basis for their IRA, reported and tracked on IRS Form 8606. That $5,000 cost basis is carried forward year after year. If any after-tax contributions are made in future years, they are simply added to the previous cost basis and carried forward.

Pro-rata rule: distributions from an IRA containing cost basis must include both taxable and cost basis funds, proportionate to the respective balances.

When a retiree begins taking distributions from an IRA in retirement and the IRA contains cost basis, then the pro-rata rule comes into play.

Let’s imagine a scenario where a retiree has a $1,000,000 balance in their IRA with a $100,000 accrued cost basis. That means $900,000 of the balance is subject to income tax and the remaining $100,000 can be taken tax free.

You may be wondering, can the retiree take a distribution from only the taxable balance or cost basis? After all, this would allow for some great tax planning opportunities. Unfortunately, no, this isn’t allowed. In the eyes of the IRS, all distributions are taken proportionally from both taxable and tax-free funds. This is known as the pro-rata rule.

In our example, since 10% of the balance is cost basis, any withdrawal will include 10% tax-free and 90% taxable funds. So if the retiree takes a $40,000 distribution, $36,000 will be taxed as income and $4,000 will be tax-free. Note: the $4,000 amount will reduce the cost basis by that same amount. The new cost basis going forward would be $96,000. Since the IRA balance will likely continue to grow, this computation needs to be made each time a distribution is made since the percentages will change. Again, all tracked on form 8606.

What does this have to do with Roth conversions?

The pro-rata rule is important to understand when it’s time for distributions in retirement, but it’s VERY important to understand if backdoor Roth contributions are being made. This is because the IRS views converted funds with the same pro-rata rule. Let’s start with an example.

Say someone has all their retirement savings in their employer plan and has $0 saved in a traditional IRA. In this case, the backdoor Roth contribution works smoothly. They can simply make a $7,000 after-tax contribution to their IRA and then immediately convert the entire amount to a Roth IRA. The $7,000 is then saved in the Roth IRA and is allowed to grow and be withdrawn tax-free!

However, say this person has a balance of $63,000 in their traditional IRA and wishes to do the same thing. They make a $7,000 after-tax contribution immediately followed by a $7,000 conversion to their Roth. No problem, right? Remember we’re talking about the IRS here.

Once the $7,000 after-tax contribution is made to the traditional IRA, this saver now has a $70,000 IRA balance with a $7,000 cost basis. You guessed it; then, when they make the conversion, the IRS states that any amount converted must be taken pro-rata from taxable funds and cost basis. This is how that would look.

Traditional IRA Balance: $63,000 ($0 cost basis)

After-tax contribution: $7,000

New Traditional IRA Balance: $70,000 ($7,000 cost basis)

Converted amount: $7,000 ($6,300 taxable, $700 cost basis)

New traditional IRA balance: $63,000 ($6,300 cost basis)

The end result: This investor has $63,000 in their traditional IRA with a $6,300 cost basis, a $7,000 balance in their Roth IRA, and an additional $6,300 reported to the IRS as taxable income. This is in addition to the $7,000 they already paid taxes on!

All IRAs count

You might think this rule can be avoided by opening a new IRA account with a $0 balance to be used for backdoor contributions (you can have more than one). However, the IRS doesn’t allow this either. The problem is, in the eyes of the IRS, all of your traditional IRAs are viewed as one aggregated account. This is called the IRA aggregation rule. This also includes SIMPLE and SEP IRAs! Simply put, if you have a balance in any one of these IRAs, then you will have this problem making backdoor contributions. The good news: qualified work savings plans such as 401(k), 403(b), TSPs, are not included in this rule. Of course, any Roth account is excluded as well.

What to do

Good news: If you earn more than IRA contribution limits and have a balance in a traditional IRA, there are still ways you can make backdoor Roth contributions.

1) Keep track: You can always just go ahead with backdoor Roth contributions and keep track of cost basis on IRS Form 8606. The math isn’t hard, it just takes some diligence and record keeping to ensure you’re not ultimately double-taxed in retirement. This will likely turn into a long-term task you or your CPA will track for dozens of years. Also, you’ll want to be sure to be aware of your extra tax liability from partially taxable conversions.

2) Move IRA accounts to employer plan: If your employer-provided retirement account allows for incoming transfers, you can move your IRA balance into your workplace 401(k). This can zero out your traditional IRA, allowing for clean backdoor Roth contributions. (Be careful not to move any cost basis into your 401(k)!)

3) Focus on conversions until IRAs are depleted: As long as it makes sense tax-wise, you can turn your attention to making Roth conversions until your IRA is depleted. This may be easier said than done. If you’re concerned about losing out on the chance to contribute to retirement savings, other account options can help. Are you maxing your 401(k)? Are you using your HSA? Do you have the option to do mega-backdoor Roth contributions with your 401(k)? Oh, and don’t forget about brokerage accounts!

Why does it have to be so hard?

When I finally get my three wishes from a genie, I’ll probably waste the first two and then ask, “Why does the IRS impose income limits to contribute directly to a Roth IRA?” Of course I’m kidding, even a genie would have no idea.

The truth is, the IRS should not care if high earners want to contribute to a Roth IRA. After all, they’re paying taxes on the contribution (at presumable a high tax bracket). Add in the fact that the IRS has tacitly approved of backdoor Roth contributions, and the limit makes even less sense. They clearly don’t care if high earners make Roth IRA contributions, as long as it is needlessly complicated. Rant complete.

Congrats

You made it. Did all that seem impossibly complicated? If so, good… I nailed it. The process of backdoor Roth contributions can get hairy pretty quick.

If this is a strategy you plan to implement, just make sure you’re working with a financial professional who can double-check your logic and math. As always, I’m here to answer your questions. Shoot me an email at Rob@prosperwitheverman.com or reach out to set up a meeting. Prospect meetings are always free.

Good luck!