'The Cream in the Coffee' Rule and Isolating Basis - Alaska Permanent Capital Management

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‘The Cream in the Coffee’ Rule and Isolating Basis

When it comes to taxation of your IRAs, there is a rule that haunts even the best tax chemist, the “Pro Rata Rule,” or better known as the “Cream in the Coffee Rule.” The reference is to how the creamer immediately taints the entire cup of coffee, and it becomes difficult to separate cream from coffee without a Bunsen burner.

There are two types of contributions that can be made to an Individual Retirement Account (IRA). If you don’t have a qualified plan through work, you can generally make pre-tax contributions to your IRA each year up to the IRS-specified limit. Those contributions are tax-deferred and grow tax-free until you take them out in retirement. If you have a plan through work, and your income is too high to make additional pre-tax contributions to an IRA, you can make post-tax IRA contributions (non-deductible). When you have both pre-tax and after-tax contributions, as well as earnings in your IRAs, you have “Cream in the Coffee.”

The Cream in the Coffee rule states that all your IRAs are considered the same IRA by the Internal Revenue Service. This means if you have pre-tax contributions in one IRA and post-tax in another, a portion of any distribution from your IRAs will be taxable, and a portion will be non-taxable. You might say, “Great, this means I pay less tax on my IRA distributions than I normally would.” Sure, but is there a better strategy within that creamy, partially-taxable coffee? The answer may lay in the two following questions.

  1. Do you have an employer sponsored plan that allows you to roll money in from an outside IRA?
  2. Are you a self-employed individual and eligible for a solo 401(k)?

If you answered yes to either of these questions, it’s time for a discussion with your APCM Wealth Management for Individuals (AWMI) financial advisor and accountant.

The mechanics are far from simple, and any tax strategy should always be run by your accountant before proceeding. The general idea is this: roll your pre-tax funds from your IRA into a qualified retirement plan, leaving the post-tax contributions behind. Once you have left your tax-free basis alone in your IRAs, initiate a ROTH conversion of those funds into a ROTH IRA. When done right, the conversion should be made up of mostly post-tax contributions, which means the conversion is likely tax free.

Many of you who subscribe to this blog have heard of ROTH conversions and the power of ROTH IRAs: tax-free growth, no required minimum distributions, efficient legacy tool for your family, and completely tax-free upon withdrawal. If you want to learn more about the power of ROTHs, check out this great article written by one of the directors at AWMI, Cathie Straub, CPA, CFP®: https://www.apcm.net/blog/financial-planning/roth/

Whether or not the strategy will be beneficial to your circumstances will depend on your comprehensive financial plan and a discussion amongst your wealth team – your CFP® professional, your CPA, and your attorney.

Think this situation might apply to you or a friend? Give us a call, and we will coordinate strategies with your wealth team.

Connor Michael, CFP®
Financial Advisor

Disclaimer: We do not give tax advice and will refer you to your accountant for a final ruling on this strategy.

9/27/21

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