For parents of college-bound children, Roth IRA conversions need to be timed wisely to maximize the Roth conversion for retirement and college aid eligibility to help pay for their children's college costs. Converting a regular IRA to a Roth IRA creates a huge spike in income that can ruin a child's eligibility for need-based college aid.
Many parents with regular IRA accounts should take a serious look at converting some of their regular IRA account into a Roth IRA because after age 59 1/2 the earnings in a Roth IRA may be withdrawn penalty and federal tax free, whereas distributions from a Regular IRA will be fully taxable. The catch is that if you convert part or all of a regular IRA to a Roth IRA, the amount of the conversion is fully taxable in the year of the conversion. Thus, you pay the tax now and withdraw the money tax –free at retirement. This is a decision that has many variables and should be evaluated with professional help. More importantly, while this may be a wise decision for retirement, the decision should also be made in the context of the potential impact on college aid eligibility.
How Roth IRA Conversion Income Impacts College Aid Eligibility
The reason that converting a regular IRA to a Roth IRA may impact your child's need-based college aid eligibility is because the conversion income will be counted on the financial aid forms, the FAFSA and the CSS Profile. You will have to report 100% of the conversion income along with all of your other income on the aid forms, but under both aid formulas taxes and other income-related allowances are subtracted from the income you report, thus lowering the amount of income that is counted in the aid formulas. After the allowances have been subtracted from the income, the aid formulas then count about 47% of the parent's net income against the student for aid eligibility purposes.
It's also important to note that while Roth conversion income is reported in the tax year of the conversion, the college aid forms for an upcoming academic year (2015-2016 starting fall of 2015) will require tax and income information from your 2015 tax return. Therefore, your base tax year is the year before the child enrolls in college.
Scenario # 1 You Have A Child In, Or A Year Away From Enrolling In College (Base Year)
(A) If your child is not likely to qualify for need-based financial aid and converting a regular IRA to a Roth IRA makes sense for tax and retirement savings, then do it. This is even better if your MAGI after the conversion will be less than $180,000 because then you can use the American Opportunity Tax Credit to offset some of the tax from the conversion. To reduce the sticker price of college, you can look for colleges where your child will be eligible for merit aid, which isn't awarded based on family finances, but your child's academic merit.
B) If your child will qualify for need-based aid, and you have an idea of what that aid package is, or may look like (e.g. meeting 100% of the student's need with grants only, a common aid policy at the many of the most selective colleges), then you have to weigh the tax and retirement benefits against the loss in need-based aid, because if you do a conversion, about 47% the after-tax conversion income will count against your child's aid eligibility. The bottom line in this situation is that if you convert to a Roth, you will lose real aid money.
However, if the aid package is small, or mostly federal student loans, the Roth conversion may be the way to go because the aid package isn't very favorable to begin with. Just keep in mind, you cannot borrow for retirement, but your child can borrow for college. Of course, you don't want to saddle your kids with excessive debt either.
Tip: Use your non-qualified assets to pay the tax on the conversion income, which Roth experts say is the most effective way to do a Roth conversion because it leaves all of the converted assets in the Roth account to grow tax-free for retirement. What's more, by reducing your non-qualified assets, which will also count against your aid eligibility, you will be able to accomplish the best Roth conversion tactic while simultaneously minimizing the conversion's impact on college aid eligibility. In the aid formulas, the after-tax conversion income will definitely count more heavily (up to 47-50%) against aid eligibility than your reportable non-qualified assets will (up to 5.64%), but the reduction in reportable assets will lessen the impact on aid eligibility.
Tip: Wait until the child's junior year of college, in the second semester (i.e. January; of the new tax year), then convert your IRA to a Roth IRA and the resulting conversion income will NOT show up for aid purposes because you will be completing the aid forms for the student's senior year using the previous year's income tax information. Once you have completed the aid forms for your youngest child's final year of undergraduate education, you basically have a green light to make financial moves without worrying about impacting aid eligibility. This is when the sprint to retirement typically begins in earnest; you're through jogging in place. It's time to get the horsepower to the pavement, and rev up those retirement accounts.
Scenario # 2 Your Child Is A Few Years Away From Entering College
Tip: Make the conversion before the income will be counted on the aid forms. Then if you want to, you may always withdraw the basis in the Roth to help pay for college without any tax or penalty, and leave the taxable earnings in the account to grow tax free for retirement. Once again, if you can use non-qualified assets like savings, money market or investments to pay the tax on the conversion income, this is the most effective way to do a Roth conversion, and will also lower the assets you have to report on the college aid forms when the time comes.
Turbo Charging Your Roth Conversion With Tax Savings And Financial Aid
If you follow these guidelines, and implement the tips that apply to your situation, it may save you a substantial amount of money on college costs and taxes. You can turbo charge your wily Roth conversion strategy by taking those reductions in cost and saving them in a new or existing Roth IRA account.
