The free posts this week explain what the pro-rata rule is and when it applies. This one shows you how to run the calculation yourself. If you manage your own accounts or work with clients who do, this is the reference you use when a conversion or distribution is on the table.
The formula.
The IRS uses one fraction to determine the tax-free portion of any Traditional IRA distribution or conversion:
Tax-free percentage = Total nondeductible contributions / Total Traditional IRA balance (December 31)
Multiply the tax-free percentage by the amount distributed or converted. That is the nontaxable portion. The rest is taxable income.
Three things to know about this formula before running it.
First, “total nondeductible contributions” means the cumulative amount of after-tax money you have contributed to any Traditional IRA over your entire lifetime, minus any amounts previously recovered tax-free through earlier distributions or conversions. This running total is tracked on Form 8606, Part I, Line 14. If you have never filed Form 8606, and you made nondeductible contributions, you need to reconstruct that history before the calculation means anything.
Second, “total Traditional IRA balance” includes every Traditional IRA, SEP IRA, and SIMPLE IRA (past the two-year holding period) in your name. Every single one. At every custodian. The balance used is the fair market value as of December 31 of the year the distribution or conversion occurs, plus any distributions or conversions taken during the year, plus any rollovers out of Traditional IRAs during the year.
Third, the formula applies to the entire year at once. You do not calculate it per transaction. If you convert $20,000 in February and take a $5,000 distribution in October, both use the same ratio.
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