What is the proportional rule? This formula is used with Individual Retirement Systems (IRAs) to determine how much of an IRA distribution is taxable when the account holder holds both after-tax and pre-tax dollars in their IRAs. This rule does not apply to the savings plan or to Roth IRAs. You must not isolate after-tax amounts and must include pre-tax funds in your IRAs.
How do you calculate the proportional rule? First, add up all of the affected IRAs. This includes SEP and SIMPLE IRAs, but not Roth IRAs.
After totaling the value of all affected IRAs, calculate the balance of US dollars after taxes. The after-tax dollars could come from non-deductible contributions to a traditional IRA. If you have several years of making non-deductible contributions, you should have tracked those contributions on the IRS Form 8606, Non-Deductible IRAs.
With the two numbers you have, calculate the percentage of dollars after taxes. You divide the after-tax dollar by the total IRA balance to get the percentage. For example, let’s say you have after-tax contributions of $ 54,000 for a total IRA value of $ 325,000. Your post-tax dollar percentage would be 16.6%.
After you know the percentage of after-tax dollars, you can calculate the taxable amount of your IRA distribution. If you had made a distribution of $ 50,000, 16.6% or $ 8,300 would be considered a return of already taxed contributions and would not be subject to federal income tax. The remaining $ 41,700 comes from pre-tax monies and is taxed at your Ordinary Income Tax rate.
But wait, we’re talking about tax law here. There must be exceptions. The exception is if your distribution is a rollover from an IRA to a business plan (e.g., thrift plan, etc.). The tax code only allows pre-tax money from an IRA to be included in a business plan. So if you are rolling money into the TSP, you can ignore the proportionate rule and just roll money into the thrift before taxes.
The other exception is that a Qualified Charitable Distribution (QCD) from your IRA doesn’t have to follow the pro-rated rule. You must be at least 70½ at the time of QCD.
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