Effects Of A Roth IRA Conversion On College Funding

by Todd Smith on 2012-03-270

Our financial affairs are often put together in a reactionary, piecemeal fashion over a period of time, perhaps based on what we hear recommended by an advisor or guru, by what we read as the tip du jour by a popular money magazine or by what all our friends or colleagues are doing. This continues until you look back and ask yourself what’s happened to your financial picture. There always seems to be a new draw that encourages us to make a reactionary decision. And based on looser regulations, some folks may be considering a Roth conversion.


Do you own a traditional IRA or 401K account? Most of us do, and perhaps at one point or another, you may have wondered whether it was a good idea to roll that over into a Roth IRA. You may already have weighed the tax implications of staying with your current account or of switching it to a Roth. But before you make that conversion, you’ll want to be aware of other consequences you may face.

Why A Roth IRA Conversion?

Let’s start with the good things that a Roth IRA conversion can do for you. Until recently, only those folks who earned an adjusted gross income of at most $100,000 could make the IRA conversion to a Roth IRA. But changes to the laws have been made such that there are no longer restrictions. And that’s a good thing! The good news here is that the money you have in a Roth IRA isn’t taxed. Thus, if you make good money and have a high income, you may want to pay your taxes now instead of later and decide to set up a Roth IRA. This would be a good thing if you’re anticipating higher income rates down the road. Another Roth IRA benefit is that you won’t need to withdraw your funds until the age of 70 1/2.

How A Roth IRA Conversion May Affect College Funding

The Roth conversion sounds great on paper (besides having to pay taxes, of course ;-) ), but it may have unexpected implications. This is an issue of financial integration: some investors may not be thinking about how a retirement account could affect their financial aid options — but it can. For instance, there’s a possibility that a Roth conversion that you perform this year could potentially affect your child’s college financial aid prospects. Many people who are eager to take advantage of less restrictive Roth account requirements may not be fully anticipating the potential ramifications of their decision. It’s not just about future tax rates.

So how can a Roth IRA conversion affect your child’s financial aid prospects? Think of it this way: here’s an example from a Charles Schwab representative: Typically, a person who earns $100,000 may be tapped for $17,000 of their kid’s college tuition. But if this $100,000 is moved into a Roth, this signifies a higher income level, which can then raise the family’s expected contribution to $48,000!

This can happen because of the way that colleges and schools view a family’s assets (or lack thereof). Whatever information that is garnered from the FAFSA (Free Application for Federal Student Aid) can be used by the educational institutions to figure out a student’s eligibility for financial aid and student loans. For instance, the FAFSA may simply focus on a family’s income and cash flow, but may disregard certain assets, such as their retirement savings or property and business holdings. By the same token, it may recognize a rollover as a trigger for added income for the year. If there is any concern over losing college scholarships due to massive IRA rollovers, then the solution here is to do partial rollovers over time. Let’s not discount this risk as I’ve read about a case where a student would have lost the majority of their expected scholarship if their parents had done a complete rollover of a six figure traditional IRA into a Roth IRA in one transaction.

 Retirement vs. College Savings?
Retirement vs. College Savings?

Because colleges and schools may be considering the impact of Roth rollovers upon family income, it would therefore make sense for families to discuss the ramifications of their retirement plans (and any partiality towards a Roth conversion) with their children’s educators, prior to making any financial moves.

It’s important to note that a lot of investors, particularly those with assets, may not take into account the impact of doing a Roth IRA conversion or rollover. There can be issues when moving your assets, savings and investments around, especially as it pertains to financial aid. Regrettably, many financial advisers aren’t thinking about it either. This is probably often the case because many people want their children to pay for their college expenses — at least a portion, if not all of it. Quite frankly, with the lack of financial retirement planning nowadays, not to mention the ancillary benefit of teaching our children responsibility, it’s not a bad retirement planning strategy to expect your kids to foot their tuition bill.

Look Before You Leap!

So what’s the moral of the story here? Note that certain schools will take a hard look at your property assets when they evaluate your situation. What may seem unfair here or even ironic is that in some cases, an individual with a lot of assets, such as an expensive home or retirement investments may actually qualify for more aid than someone with fewer assets to their name but with a higher income. So take note about how you manage your finances!

The most important takeaway here is that you simply have to make sure that all your financial decisions are working in concert. A decision to convert to a Roth could very well increase your college expenses. Will your child be able to afford college after your Roth IRA conversion, or will you find yourself suddenly strapped with the responsibility of making up the difference? Will it delay — or worse, completely derail — your own retirement plans? Just make sure you are familiar with the Roth IRA rules and that you research all of the pros and cons before you jump on the Roth conversion bandwagon!

The New York Times shares more on this subject.

Created November 22, 2010. Updated March 27, 2012. Copyright © 2012 The Digerati Life. All Rights Reserved.

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