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The Pro Rata Rule and 401K Discrimination Tests

To date I have featured a decent number of posts on the wonders of tax advantaged investing. To that body of work I want to add one additional post, exploring the odds and ends of tax advantaged accounts. We’ll focus here on less known, but important especially to high income professional, rules of some of these accounts.  Of particular interest will be the Pro Rata Rule and 401K Discrimination Tests.

Before we get into the nitty gritty I might recommend you start with our post ranking and discussing all the various tax advantaged accounts. It will give you a good primer for all the options in this space. With that lets dive in.

401Ks and the Pro-rata rule

I have spoken at length about 401K’s and even referenced some aspect of leveraging a Roth 401K versus a Standard 401K. The answer, as I noted in that post, can sometimes be to do both. There is only one real risk with this approach, the pro-rata rule.

In the case of a 401K with mixed pre and post tax money, whether it is because of a Roth 401K or after tax contributions for an in-service rollover, withdrawing funds has to be done in proportion to the funds in the accounts. So if I had a 401k with 10% Roth and 90% Traditional. Pulling the money out to rollover to a different plan, or really any type of distribution, would require execution as 90% Traditional and 10% Roth regardless of how much you withdrawal. This means in some ways combining both accounts locks you in to withdrawing both pre and post tax funds at the same time.

Now thankfully the IRS took pity on some of us that do these actions. They explicitly allow you to redirect these moneys to different accounts. So you can actually roll the 10% to a Roth IRA and the 90% tradition to a traditional IRA. This means in theory you can avoid being forced to pay taxes on your rollover.

IRAs and the Pro Rata Rule

Now things are a bit different for us on the IRA side. In the case of the 401K the pro-rata rule applies only to single plans with mixed taxation. But in the case of an IRA it applies to an aggregation of all your traditional IRA accounts. So once you roll your mixed 401K separately to both a Roth IRA and a Traditional IRA, you essentially make your life more difficult if you ever need to do a Roth IRA conversion.

So if you take an action like an in-service distribution of after tax 401K money you will be forced to push pretax money from your 401k into a Traditional IRA. If you do a Roth IRA conversion with new money you put after tax money into the traditional IRA and convert it to a Roth. The issue is once you mix the money in your traditional IRA it’s considered one big pot, so pre and post IRA has to be withdrawn at the same time. This makes it difficult to impossible to move out the after tax money without disrupting the pretax money.  So having money sitting in your traditional IRA from an in-service rollover basically closes the door to future Roth Conversions.

Exceptions to the Pro Rata Rule

But… There are some exceptions before I get off this topic. The exceptions are

  • Inherited IRAs
    Inherited IRAs are not aggregated for the purposes of the prorate rule. This also means they are not aggregated for RMDs and other areas of tax law.
  • Rolling a Traditional IRA to an Employer 401K
    If your employer allows you to go the other way you can do so without moving the taxable IRA out

So the effectiveness of the Mega Back Door Roth using after tax 401K contributions appears to hinge most on whether your employer allows roll ins of Traditional IRA money.  Alternately a Solo 401K may also serve this purpose.

401K Discrimination Testing

The other rule I wanted to highlight today is the 401K discrimination testing rules. Once a year 401K plans are tested to ensure they do not unfairly favor higher income employees. The IRS divides employees into highly compensated and other employees.  Highly compensated employees are defined as those above 120K a year, owning more than 5% of the business, or were in the top 20% income of employees.

These tests then look at things like the policies and actual usage of your corporations 401K plan. If they tilt to heavily to those in the highly compensated group, then a business has one of two choices.

  1. Pay extra amounts to the non highly compensated group
  2. Declare a portion of Highly Compensated Employee contributions as taxable and distribute them until they bring the plan back in line.

This has some hefty impacts for those at the higher end of the pay scale. For one if you did a Mega Backdoor Roth and this happened you’d end up paying a penalty since you would have contributed more to your Roth then you were allowed. Even without the conversion you’d end up paying more taxes then expected. Nasty, and usually something you won’t find out about your employer until they do calculations after the first of the new year.

How To Determine If Your Employer Will Fail Discrimination Tests

Now, some things to look out for that might allow you to predetermine if this is coming. Some plans are consider “safe harbor” and are usually not subject to this testing. To be considered a safe harbor a plan essentially needs to have an employer contribution to the plan.  And you wondered why matching was so common.

To be specific the plan must do one of a dollar for dollar match for all participating employees on the first 4% of compensation,  a dollar for dollar match contribution on the first 3% and 50% match for the next 2%, or contribute 3% of employee compensation each year.  These matches have to be 100% vested and not available for in-service withdrawal before 59 1/2.  A note, the lack of in-service withdrawal applies only to matches.  If you are highly paid and your employers 401K does not have these features then you should be on the lookout for the possibility of a failed test.

Some other things can trigger testing regardless of safe harbor status. These are:

  1. An employer makes a discretionary profit sharing contribution
  2. An employer makes a discretionary match.
  3. Non Roth After Tax contributions are made by a participant.

Mega Back Door Roth, Discrimination Testing In Full Effect

Which brings us back to the after tax Mega Backdoor Roth. This is the definition of item 3.  You have to be very careful if you do a Mega Back Door Roth as it will be compared to what lower income folks do in the after tax space.  If they do not do enough after tax contributions the money will be returned to you. If you have already done a conversion you will end up with a penalty.

Our Mega Back Door Roth Experiment

As noted last year I am experimenting with the Mega Backdoor Roth this year. I am considered a highly compensated employee and I suspect I am in the top 20% by pay. As such I’ve only put in a small amount after tax. I also am waiting to convert to a Roth until after testing completes.

Anyone ever work at an employer that failed 401K discrimination testing? Anyone struggling with the Pro Rata rule?

As always please note Full Time Finance is for entertainment purposes only. Please consult a tax accountant for complicated transactions.

16 Comments

  1. Steveark
    Steveark March 7, 2018

    It was always irritating to have to get an unexpected refund from my 401k and it happened about 2/3d’s of the years I worked. It meant you couldn’t file taxes to the very last minute because there was never any warning. I was a highly paid engineer/manager and the company had many more lower paid truck drivers in the same plan that didn’t participate at the same level so we were always on the edge of being top heavy. I was already maxed out with either a post tax IRA or a Roth when I was eligible so that refund just had to go to a brokerage account. They did finally go safe harbor but only shortly before I early retired. I suspect I missed out on several hundred thousand extra dollars in my 401k at the end of the day but it is hard to say whether the flexibility of having pretty large non-qualified accounts now doesn’t have it’s own advantages.

    • FullTimeFinance
      FullTimeFinance March 7, 2018

      Ouch… one has to wonder what might have been.

  2. MrWow
    MrWow March 8, 2018

    Yeah this is certainly rough. I know for a while I was getting returns from my contributions, and I had no idea why. Now I know.

    I also always wondered why the MBDR was so rare. And now I know why. All this compliance testing is pretty interesting.

    One thing to be aware of… for small businesses. SEP & Simple IRA’s count toward your Tax Deferred IRA bucket for the pro-rata rule, so that’s another reason to look into the Solo 401k. And Fidelity allows you to do Trad IRA roll-ins, while Vangaurd doesn’t, so you can get your Trad IRA balance to 0 allowing for all these fancy maneuvers. Just food for thought…

    Thanks for the heads up.

    • FullTimeFinance
      FullTimeFinance March 8, 2018

      Great add regarding which solo 401ks allow rolling from a traditional ira. I really enjoyed your post from a perspective 401k plan design perspective.

  3. Mr. 39 Months
    Mr. 39 Months March 8, 2018

    My company has this issue. While I could put up to 15% of my salary in, I only put in 6% (they match 1/2, up to 3% – so I go with 6%).

    Even with this, I get some money back.

    It frustrates me that people in the company aren’t even willing to put in money for the match!

    Mr. 39 Months

    • FullTimeFinance
      FullTimeFinance March 8, 2018

      Sadly there is not much we can do as employees, other then petition our employer to go safe harbor.

  4. Drewski
    Drewski March 10, 2019

    Does the pro-rata rule have a timeframe for when it gets applied?
    For example, my wife and I are interested in doing a backdoor Roth this year. I rolled my Traditional IRA into my employer’s 401k last year, and my wife completed the same with her employer’s plan early this year. Does the Pro Rata take the balances as of the beginning of the year, the end of the year, or the balances at the time the transaction/contribution is made? Or is there some form of averaging that needs to take place?

    • FullTimeFinance
      FullTimeFinance March 11, 2019

      Great question. The pro Rata rule uses balances as of the end of that year, so it can change from the time of execution.

      • Menlo Mom
        Menlo Mom May 6, 2021

        So does that mean for Drewski that since their traditional IRAs essentially don’t exist at the end of the year (they converted during the year) – that the only taxable IRA would be their non-deductible that converts to Roth – so no pro-rata. Can the do both the conversion and the backdoor in the same year – since end of year balance is all that matters?

        • FullTimeFinance
          FullTimeFinance May 9, 2021

          No as the balance at end of year is reconstituted to include contributions, conversions and distributions throughout the year.

          The equation is actually total after tax /(balance +distributions + conversions+outstanding rollovers)

  5. HO
    HO June 9, 2021

    So I did backdoor Roth by contributing $6K to Traditional IRA and converted to Roth. I basically setup new Traditional IRA and Roth accounts on TdAmeritrade. At that time, I did not know about prorate rule. I also did an IRA rollover account from previous 401K conversion (wish I had read this and not done it). The rollover was reported on form 5498 after I filed the taxes. What options do I have now – current employer does not allow converting rollover IRA to current employer 401K. I read that I need to report all this on Form 8606 and will be subject to prorata rules. I also don’t understand if IRS has track of all my traditional IRA accounts and Roth accounts to determine accuracy of Form 8606 that I file. And basically it also does not make any sense for me to do backdoor Roth in future? Can you give me some advice.

    • FullTimeFinance
      FullTimeFinance June 16, 2021

      For the IRA I would contact TD Ameritrade and they can either reverse and or recharacterize as a Roth contribution.

      For the rollover, do you have any sort of 1099 income? One way would be to create a solo 401k and roll it into that.

  6. Robert Paulson
    Robert Paulson August 1, 2021

    If the tax payer has a Trad IRA, how does the pro-rata rule apply to after-tax 401k balance rolled-over/converted to a Roth IRA?

    For example using the below, how is pro-rata applied to after-tax 401k to Roth IRA conversions for the following scenarios?

    1.) $100 IRA
    2.) $10 Roth IRA
    3.) $150 401k (Traditional)
    4.) $10 after-tax 401k (assume zero gains)
    5.) $50 401k (Roth)

    Scenario A: Items 3.) and 4.) are SEPARATE.

    Scenario B: Items 3.) and 4.) are COMBINED.

    Thanks for the advice!

    • FullTimeFinance
      FullTimeFinance August 1, 2021

      It goes without saying consult your tax attorney for your own scenario. However the IRS rules would treat the IRAs as one account and the 401k would be one only if they were combined.
      So if 3 and 4 are combined you would have to withdrawal from 3 and 4 at the same time. If 3 and 4 are separate then you don’t need to do so.

      • Robert Paulson
        Robert Paulson August 2, 2021

        Hello – Thank you. I completely agree about the tax attorney. For now, I’m just trying to get a basic understanding of how this rule is applied. The statement “the IRS would treat the IRA as one account and the 401k only if combined” is where I’m a little confused. Does this mean:

        A) If after-tax 401k is separate from Trad 401k, the Trad IRA does not invoke the pro-rata rule when when converting to after-tax 401k to Roth IRA?

        B) Then if after-tax 401k is combined with Trad 401k, the the after-tax 401k is subject to pro-rata rule based on the balance of the Trad 401k?

        Sorry if your response answered what I just posted, but I wanted to repeat my understanding to confirm.

        Thank you for your help. Much appreciated.

        • FullTimeFinance
          FullTimeFinance August 3, 2021

          So seperate or combined comes down to if the money is in the same 401k plan. If I had two seperate plans then they don’t pro rata together. So for example if I had an old 401k from a former employer, what I do with my current employer 401k is unrelated.

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