What is the IRA Aggregation Rule

Comments Off

The IRA aggregation rule is an IRS rule that stipulates that all traditional, SEP, and SIMPLE IRAs owned by an individual to be treated as one for tax purposes when calculating the taxable amount of an IRA distribution or conversion to a Roth IRA. This rule becomes particularly important during the Roth conversion process, as it dictates how the pre-tax and after-tax amounts in your IRAs are considered.

The IRA Aggregation Rule has two primary implications:

All Traditional, SEP, and SIMPLE IRA’s are totaled for the purposes of distributions.
Each distribution is a pro-rata distribution of pre-tax funds and basis.

Cream in the Coffee

To help you understand the IRA Aggregation Rule, imagine your IRA funds as a cup of coffee, with pre-tax contributions being the coffee and basis contributions being cream. When you initially pour cream into your coffee, it swirls around and mixes uniformly. Once mixed, there’s no way to extract just the cream (basis contributions) without also getting some coffee (pre-tax contributions) in your spoon.

This analogy is akin to how the IRA aggregation rule works when converting from a traditional IRA to a Roth IRA. If you have made both pre-tax (deductible) contributions and basis (non-deductible) contributions to any of your traditional IRAs, these contributions are mixed together like cream and coffee. When you decide to convert a portion of your IRA funds to a Roth IRA, you cannot choose to convert only the after-tax “cream” and leave behind the pre-tax “coffee”. Instead, each dollar you convert consists of a proportional mix of pre-tax and basis money, based on the total balance of all your IRAs.

The IRA Aggregation Rule for Roth Conversions

When performing a Roth Conversion, it is important to understand the tax implications of performing the conversion when you hold

Here’s how to determine the taxation of a Roth Conversion with Multiple Accounts:

When you make a distribution or a conversion from any of your IRAs, you must include all traditional, SEP, and SIMPLE IRAs to determine the proportion of after-tax and pre-tax funds.
The total of your basis across all your IRAs are divided by the total balance of all these IRAs to determine the percentage of any distribution or conversion that is non-taxable.
The remainder of the distribution or conversion is considered taxable.

For example, if you have a $50,000 Traditional IRA with $5,000 in basis and a $200,000 SEP IRA with no basis. If you perform a $5,000 Conversion from the Traditional IRA to a Roth IRA, here is how it will be taxed:

Total All Traditional, SEP and SIMPLE IRA’s: $50,000 + $200,000 = $250,000
Calculate Percentage of Total Accounts that are Basis: $5,000 / $250,000 = .02 or 2%
Calculate the Dollar Value of the Conversion that is Non-Taxable and Taxable:

Non-Taxable
Conversion Taxable
Conversion

$5,000 5000

x 2% 98%

$100 $4,900

While the conversion of $5,000 was equal to the basis in the Traditional IRA, most of the conversion was actually taxable and not from basis because of the IRA Aggregation Rule. After this conversion, what you are now left with is a $45,000 Traditional IRA with $4,900 in basis and a $200,000 SEP IRA.

Summary

Understanding the IRA aggregation rule is essential for anyone considering a Roth IRA conversion. Like mixing cream into coffee, once different contributions are in your IRA, they cannot be selectively converted without including both taxable and non-taxable portions. Properly managing this rule can lead to significant tax savings and a more efficient approach to retirement planning. As with any financial decision, it is advisable to consult with a professional to fully understand your options and the best strategies for your circumstances.