Most individual retirement accounts are subject to an aggregation rule when calculating tax consequences to prevent abusive tax strategies. The IRA Aggregation Rule, as it is called, specifies that when determining the tax consequences of an IRA distribution, the total value of all IRA accounts must be added together for the purpose of tax calculations.

Interestingly enough, the IRA Aggregation Rule does not apply to employer retirement plans like 401(k)s, 403(b)s, or profit sharing plans. Additionally, inherited IRAs are not aggregated together with an individual’s IRAs and neither are Roth IRAs. And because these tax calculations are done individually, even on a joint tax return, a spouses IRA would not be aggregated either.

Recently, the rules were also applied to limit IRA Rollovers to no more than one 60-day rollover in a 12 month period. Alternatively the rule can be used in a client’s favor by allowing an investor to take all of their required minimum distribution from one IRA.

Traditional IRA Distributions

Because traditional IRA contributions are typically tax deductible distributions those funds are 100% taxable and this rule rarely comes into play.

Conversely, when a portion of an IRA has non-deductible contributions the aggregation rule must be considered. The main impact of this rule applies to distributions when you need to calculate how much of an IRA’s non-deductible contributions are treated as after-tax return of principal, especially during a Roth IRA conversion. All IRA accounts are aggregated together and thus, the rule limits the viability of transacting a “back-door” Roth.

Any time an IRA has received non-deductible contributions, the distribution of that money is received by the investor as a return of contributions and is not subject to tax.  However, this calculation is done on a pro-rata basis and is subject to the aggregation rule. Meaning, you can’t just pull out the non-deductible contributions and avoid tax. For example, if you have an IRA and 50% of it is after-tax money, half of your distribution would be subject to taxes. This becomes even more complicated when working with multiple IRAs. Let’s say you have one traditional IRA that is 100% pre-tax dollars and one IRA was funded with after-tax money. Simply making a distribution from the after-tax account still requires that you aggregate the balances from both accounts and pay taxes on a pro-rata basis even though you already paid taxes on all of the contributions to that account.

Roth Conversions

It’s important to remember that the aggregation rule applies to all distributions from traditional IRAs, including Roth IRA conversions.

It’s fairly straight-forward to understand that if you convert $100,000 of traditional IRA money to a Roth IRA you will pay tax on the $100,000 distribution. Even if you are only converting an IRA that is 100% after tax dollars, if you have another IRA with pre-tax dollars these accounts must be aggregated for the conversion.

Occasionally, we see this with “back door” Roth conversions. An investor may make non-deductible IRA contributions to a separate IRA then convert that money to a Roth account. This is appealing when two conditions are met: 1) Income is too high to make deductible contributions to an IRA and 2) income is too high to make Roth contributions. Employing this strategy can allow high income investors to make Roth contributions when they normally could not. The aggregation rule can derail this process when an investor has previously invested pre-tax dollars in the same or another IRA.

Remember though, 401(k) dollars are not calculated in the aggregation rule and do not limit this strategy.  Additionally, traditional IRA money that is rolled into an employer plan, like a 401(k), is also not used in the pro-rata formula

Rollover Rule

Historically, the aggregation rule was used to calculate tax consequences of distributions. In recent years the rule has been adopted to apply to traditional IRA rollovers as well. The once-per-year IRA rollover rule mandates that when money is rolled from one IRA to another an additional rollover cannot occur for another 12 months. Originally, this was interpreted to mean that additional rollovers could not occur from neither the old IRA nor the new one while other IRAs were fair game. In a court case where the investor made an error in his execution of a rollover strategy the IRS determined that the IRA

Aggregation Rule should apply to traditional IRA rollovers as well starting in 2014. Meaning, that if you rollover one IRA in part or in whole, another rollover is not permitted across all IRAs for 12 months. Again, this rule does not apply to employer plans like 401(k)s. It is also important to remember that this rule does not apply to trustee-to-trustee transfers, the method by which one would move money from one advisor to another. In order for a “rollover “to occur, the investor needs to actual take possession of funds.

Required Minimum Distributions

Applying the IRA Aggregation Rule is typically a burden taxpayers and the exception to this is when considering required minimum distributions or RMDs. This is advantageous to investors because they can satisfy their RMD requirement for all IRAs by making a distribution from one IRA. The advantage is that while one IRA may hold assets that are substantially less liquid than another (like CDs or annuities), the required distribution from both can come from the account with the more liquid securities. Like stated earlier though, inherited IRAs are not part of this calculation. RMDs from those accounts must be calculated and taken separately from an individual’s own IRA accounts. Neither included are spousal IRAs, employer plans, or profit sharing plans.

Substantially Equal Periodic Payments

Another exception to this rule is when an early retiree is taking withdrawals from an IRA under the “substantially equal periodic payment” rule or what’s called 72(t) payments. 72(t) payments are an allowable exception to the early withdrawal penalties applied to IRA distributions for people younger than 59 ½. The reason these are not aggregated is that if a retiree were to begin receiving additional 72(t) payments from a different IRA it could potentially trigger retroactive penalties in the original IRA should the two accounts be aggregated. Fortunately, each account is treated separately.

The pro-rata formula is applied to the distributions of those accounts should any of the contributions to those accounts have been after-tax. Only the 72(t) calculation is done account by account.

It’s important to get these calculations right and not following these rules can result in serious tax penalties. Before implementing any of these strategies please consult with a tax advisor who can help with your specific situation.

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