The IRA You Forgot You Funded

The math the IRS won't let you skip

Joe sat across from me, proud of his spreadsheet. He had mapped out a five-year Roth conversion plan, aiming to fill his lower tax brackets between retirement and age 73, just like we discussed before. The numbers were straightforward and the assumptions made sense."Simple," he said. "I convert twenty thousand a year, pay tax on twenty thousand a year, and that's it."Then I asked him a question that changed his tax situation: Had he ever made a nondeductible contribution to a traditional IRA?He paused. "Maybe. Back in the nineties, when I made too much to deduct my IRA contribution one year? My old accountant said just put it in anyway."That answer meant Joe's conversion plan was more complicated than he thought. He had after-tax money in an account he had treated as fully pre-tax for thirty years. The IRS has a rule for this situation called the pro rata rule, which can affect how much of each Roth conversion is taxed.A reader named Investor1 asked about this rule in the comments on the last article. I think it's worth explaining fully, since it changes the math for anyone who has made nondeductible IRA contributions or rolled over after-tax 401(k) money.

Pre-tax and after-tax money in the same account

Most people put pre-tax dollars into their traditional IRA. You contribute, take a deduction, the money grows, and when you withdraw it or convert it to a Roth, every dollar is taxable income. This is the usual assumption in conversion planning, including the earlier article about using your conversion window. For most people rolling over an old 401(k), this holds true. The whole balance is pre-tax, so every dollar converted is taxable, with nothing extra to figure out.But not every dollar going into an IRA gets a deduction. If your income was too high in a given year, or you chose not to take the deduction, you can still put money into a traditional IRA. You just don't get the tax break when you contribute. The IRS calls this after-tax basis, and it's tracked on a form most people file once and never think about again: Form 8606.The problem is that basis doesn't stay in its own tidy bucket. It mixes into the same account as your pre-tax contributions and earnings, and over enough years, most people lose track of which dollars are which. Joe certainly had. He remembered making the contribution. He had no idea the paperwork existed, let alone where it was.

Why you can't just convert the after-tax part

Here's where a lot of people, including some who do remember their after-tax contributions, get tripped up. The instinct is to think: "Fine, I'll just convert the after-tax portion first. That money's already been taxed, so I can move it to a Roth for free."You can't do that. The IRS uses what's called the aggregation rule, which treats all traditional IRAs you own as a single account for tax purposes, regardless of how many custodians or account numbers are involved. You don't get to cherry-pick which dollars come out first. Instead, every conversion (and every withdrawal) is deemed to carry the same ratio of pre-tax to after-tax money as your total traditional IRA balance on December 31 of that year.That ratio is the pro rata rule. It applies whether the after-tax money came from nondeductible contributions you made directly, or from rolling over after-tax contributions out of an old 401(k). Either way, once that money lands in a traditional IRA, it's blended in with everything else, and any conversion pulls out a proportional slice of both.

Working the numbers

Let's put real numbers to it, close to Joe's actual situation. Say Joe has $475,000 across his traditional IRAs. Of that, $25,000 is after-tax basis he can document from old Form 8606 filings, and $450,000 is pre-tax money from deductible contributions and decades of growth. That's a basis ratio of about 5.3 percent.Now say Joe converts $20,000 this year, exactly as his original plan called for. Under pro rata, roughly $1,053 of that conversion comes out tax-free (the after-tax portion), and the remaining $18,947 is taxable income. He still owes tax, and the bill is still close to what he expected, since his after-tax basis is small relative to the whole balance. But the calculation isn't "convert $20,000, pay tax on $20,000." It's "convert $20,000, pay tax on 94.7 percent of it," and that ratio applies to every conversion he does until the basis is used up.The math gets more consequential the larger the after-tax basis is relative to the total. Someone who made nondeductible contributions for several years in a row, or who rolled a meaningful chunk of after-tax 401(k) money into an IRA, could have a basis ratio of 15 or 20 percent instead of 5. At that point, the tax-free portion of each conversion is large enough that ignoring it means overpaying, and getting the ratio wrong (in either direction) throws off the multi-year bracket planning that makes a conversion window valuable in the first place.

The backdoor Roth trap

The pro rata rule can also cause problems in the other direction, and this is what often surprises people.The backdoor Roth is a strategy for high earners who make too much to contribute directly to a Roth IRA. You put after-tax dollars into a traditional IRA (no deduction, since your income is too high), then quickly convert that money to a Roth, often within days. If you have no other traditional IRA money, the conversion is tax-free because you're converting dollars that were never deducted.The problem is that "in isolation" rarely happens. If you also have an old rollover IRA from a previous employer's 401(k), the aggregation rule includes that balance too. For example, if you contribute $7,000 to a traditional IRA and convert it right away, hoping for a tax-free backdoor Roth, but you also have $493,000 in a rollover IRA, all pre-tax, your total IRA balance is $500,000 and your basis is $7,000, or 1.4 percent. That means your $7,000 conversion is only 1.4 percent tax-free and 98.6 percent taxable, so about $6,900 counts as ordinary income, which is the opposite of what you wanted with the backdoor Roth. You didn’t go through the back door at all.This is the scenario Investor1 was likely picturing, which is that the backdoor Roth only works cleanly if you have no other pre-tax traditional IRA money anywhere. If you do, one common fix is a reverse rollover, moving your traditional IRA balance into a current employer's 401(k) before doing the backdoor contribution, assuming your plan accepts incoming rollovers. That empties the traditional IRA pool, so the aggregation rule has nothing pre-tax left to blend in, and the backdoor conversion goes through close to tax-free again. It's a step worth taking before you contribute, not after, since pro rata is calculated on your balance as of December 31 of the conversion year.

Why this stays hidden

This is more of a Tax Architecture problem than a math problem. The math itself is a formula. What trips people up is that the inputs to that formula live in paperwork most people forget exists.Form 8606 is only filed the year you make a nondeductible contribution, or the year you take a distribution that includes basis. If your accountant filed it correctly at the time, it's sitting in a tax return from a decade or three ago. If you switched preparers, moved, or simply never got a copy, that history can be genuinely difficult to reconstruct. And because nondeductible contributions don't show up as a distinct line item on your IRA statement (they just look like regular contributions once they're inside the account), there's no annual reminder that this basis exists.Old 401(k) rollovers add another wrinkle. If a former employer's plan allowed after-tax contributions over the regular pre-tax and Roth options (some plans do), and you rolled the whole balance into a traditional IRA rather than splitting it correctly at the time of rollover, that after-tax money is now blended into the IRA just like a nondeductible contribution would be. Joe, it turned out, had done exactly this in 2009, which is where most of his $25,000 in basis actually came from. The nondeductible contribution he half-remembered was a much smaller piece of it.

What to do about it

The first step is figuring out whether this applies to you at all, and that means pulling your tax return history. Go back through old returns looking for Form 8606. If you've used the same accountant for years, ask them directly whether you have any on file. If you've switched preparers or done your own taxes at some point, you may need to request transcripts from the IRS, which keeps records of filed forms going back further than most people expect.If you find basis you can document, the next step is making sure it's carried forward correctly on your current return before you convert anything. Form 8606 has a cumulative basis line specifically for this. It needs to reflect your full after-tax history, not just the most recent contribution. This is also the moment to involve whoever is preparing your taxes this year, since a missed basis figure either costs you money (if you pay tax on dollars that should have been tax-free) or creates a problem down the line (if the IRS's records don't match what you're claiming).If your records are thin and you can't reconstruct your basis, it's worth deciding how aggressively to pursue it. For a small ratio like Joe's, the dollar impact is modest, and reasonable documentation is enough to move forward. For a larger, murkier basis, it is probably worth talking with your prior custodians or a tax professional who can pull IRS transcripts on your behalf before you lock in a conversion schedule.Finally, once you know your ratio, build it into the conversion window math itself. The bracket-filling strategy from the earlier piece still works. You're just solving for the taxable portion of each conversion rather than the full dollar amount, which usually means converting a slightly larger balance each year to end up in the same bracket.Pro rata doesn't usually change whether a Roth conversion strategy makes sense. It changes the arithmetic underneath it. Get the ratio right before you build the plan, not after you've already paid tax on it.

This is a companion piece to How to Actually Use Your Roth Conversion Window. If you haven't worked through your own conversion math yet, start there.

The worksheets and essays can take you a long way on your own. If you would rather have the full plan built with you (or for you), start here with the application.