I am 70 ½ years old in 2016 and have to take Required Minimum Distributions from my IRA account. My IRA account balance was about $200,000 at the end of 2015. I have $40,000 in retirement income per year. What is the limit for how much I can convert to Roth in one year?
The legal answer to this question is: there is no limit. The practical answer is: it depends on a number of things.
There is no law against converting your entire IRA account balance to a Roth IRA in one year, no matter how large it or your annual income is. In fact, this can be an extremely helpful strategy for many people, particularly if they are young.
What really limits a Roth conversion is the practical consequences. Whatever you convert is counted as taxable income that year, which means that if you converted the whole account to a Roth IRA in one year, you would pay taxes on the whole $200,000 account balance, not just the amount you withdrew for an RMD. (It is also important to note that you must withdraw your RMD before you do a Roth conversion and the RMD has to stay in a taxable account; it cannot be converted to Roth with the rest of the account.) This means that you have to consider whether your taxable savings can comfortably handle the additional taxes you will have to pay.
Assuming you are married, take the standard deduction, your $40,000 of income is fully taxable at ordinary income rates (which it wouldn’t be if it was Social Security), and your normal taxable income would be around $19,400. This would put you in the 15% income tax bracket.
You have to take your RMD, which would be $7,299. Withdrawing the remaining $192,701 would put you in the 28% income tax bracket. Because of how the tax brackets work, you don’t pay 28% on the whole thing, but 15% on a certain amount, then 25%, then 28%. The tax on the amount you convert would be $45,340.
The advantage of Roth conversion is that while you pay tax on the money now, you will never have to pay tax on it again whereas with a Traditional IRA, you will have to pay tax on it eventually. The advantage is greatest when your tax bracket in the future will be higher than it is now. If your RMDs will come out when you’re in the 28% bracket, but you’re currently in the 15%, then it’s clearly beneficial to convert some to a Roth if your savings can handle it in the short-term.
So, the “limit” of Roth conversion depends to a high degree on your future tax scenario. If you’re already 70 ½, your tax situation is probably going to be stable in the near future, so you likely won’t be gaining this advantage from conversion. But even if your tax bracket later will be the same as it is now, Roth conversion can still help you.
The assets you have invested in a Traditional IRA or Roth IRA will grow over time. When you withdraw them, you will have to pay tax on their appreciation. In a Traditional IRA, all money withdrawn is taxed at ordinary income rates, including the capital gains on your assets. In a Roth IRA, nothing is taxed after you have paid to convert the assets to the Roth in the first place. That means the growth on the investments in a Roth IRA will never be taxed at all.
The longer the assets will be growing, the greater advantage there is to having the money in a Roth IRA instead of a Traditional IRA. Across rolling 30-year time periods, the S&P 500 had average annualized returns of over 10%. With that average rate of return, it only takes seven years for your investments to double in value. Making that much growth non-taxable instead of taxable at ordinary income rates is extremely valuable.
These types of savings can easily outweigh the short-term hit you take from paying taxes on conversion, even when you consider the fact that paying a large amount now reduces the amount of assets that could have compounded if you didn’t have to pay the tax on conversion.
Again, there is no legal limit on Roth conversion.
The first practical limit is your taxable savings: can you pay the tax on conversion?
The second is how much higher your future tax bracket will be than your current one and how large your Traditional IRA is; if converting your whole Traditional IRA would cause you to match or exceed your future tax bracket, you should not convert the whole thing at once.
The third limit is how long you will have to invest your retirement assets. The longer you have to save, the greater the benefit. This factor can even make it advantageous to convert enough to make your current tax bracket higher than you future tax bracket. For example, if you never need the funds, Roth IRAs make great estate planning tools and a conversion now could save your heirs money. If, however, you would need to withdraw from your Roth assets soon and would be investing them in something with low return and high stability like bonds, then making their future growth non-taxable is of less value to you.
Roth IRAs have such favorable rules that the question of whether or not to convert is usually simple – the answer is almost always yes. The next question, how much to convert, is complex and it is worthwhile to discuss the matter with someone who not only understands the tax code but also personal finance, especially retirement planning. You shouldn’t have to have a less comfortable retirement because of the absurd and needless complexity of our tax system. Finding an expert in this field is invaluable.
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