The “pro-rata rule” affects distributions from retirement accounts. This rule requires that pre-tax and post-tax money be withdrawn proportionally from retirement accounts.
Currently the Thrift Savings Plan requires that, for those of us with both Roth and traditional balances in our account, our withdrawals be proportional. If your TSP account were 60% traditional and 40% Roth, 60% of each withdrawal would come from your traditional balance (and would be fully taxable) and 40% would come from your Roth balance (and would not be taxable if your withdrawal was qualified). In order for a withdrawal to be qualified, five years must have passed since January 1 of the year in which you established your Roth balance and you must be at least age 59 ½. In September of 2019, at the same time the changes mandated by the TSP Modernization Act are implemented, the TSP will allow participants to specify from which balance (Roth or traditional) they want their withdrawal to come. We’ll not have to worry about proportional withdrawals any more.
As it applies to Individual Retirement Arrangements (IRAs) the pro-rata rule is different and more confusing. If you have one traditional IRA and there is both pre-tax (deductible) and post-tax (non-deductible) contributions within it, the proportion of pre versus post tax contributions determines how much of each withdrawal will be taxable.
However, if you have multiple traditional IRAs, the taxation is figured differently as the accounts are aggregated to determine the part of the withdrawal is taxable. In this case, you would take the total balance of all your IRAs and divide that into the total balance of all after-tax amounts in all your IRAs. That percentage will determine the proportion of your withdrawal is subject to federal income tax.
But wait! There are exceptions to the pro-rata rule for IRAs. First, Roth IRAs are not included in computing the taxable amount; the rule only applies to traditional IRAs. Second, any retirement savings that are not in a traditional IRA (e.g., TSP, 401(k), etc.) are also not included. Lastly, any money in an inherited IRA isn’t used.
Confusing? You bet! Before withdrawing from an IRA it is wise to either review IRS Publication 590-B, Distributions from Individual Retirement Arrangements, or to consult with a financial advisor or tax accountant.
More on TSP Roth Balances at ask.FEDweek.com