Since January 1, 2010, taxpayers have had the ability to convert a tradition IRA into a Roth IRA. This is despite income or tax-filing status. Before 2010, Roth IRA conversions were only allowed for taxpayers with income under $100,000. With a traditional IRA, contributions are made with before-tax dollars. On the other hand, contributions to a Roth IRA are made with after-tax dollars. In addition, distributions from a Roth IRA are not taxable, while they are for a traditional IRA.
Although, distributions from a Roth IRA are only tax free if the account has been opened for at least five years and the owner is over 59 1/2. So, the question many have is whether they should use money from their IRAs to help pay for college tuition or if their IRA accounts affect financial aid eligibility and award amounts. Given that IRAs are something intended for retirement, many households are wondering if they will need to do something with their IRAs now to help cut associated costs of college tuition. Then, there is the question of whether you should avoid making Roth IRA conversions until after college graduation.
The good news is assets in an IRA–whether it belongs to the parent or the student–are not included in financial aid calculations. Yet, IRA withdrawals are included in income calculations. When money is withdrawn from a child’s IRA, it is considered student income. Federal financial aid formulas anticipate students will contribute 50 cents of every $1 earned (after an allowance of around $6,400) for college costs. If the parent, or the student, wants to convert a traditional IRA to a Roth IRA, then the outcome is taxable income included in the taxpayer’s adjusted gross income. The income from the conversion is also reported in a single tax year.
Furthermore, income taxes are based on earnings and before-tax contributions. This means that converting from a traditional IRA to a Roth IRA can put the taxpayer into a higher tax bracket. As a result, it can affect eligibility for student financial aid. This can produce an undesirable effect, especially if it is the student’s account. The reason is the dependent student’s assets count for more–even if they are funded by other people’s money. On the FAFSA, most money and property are counted as assets.
Although, the FAFSA does not ask about the value of traditional or Roth IRAs. If parents want to increase the odds of a larger financial aid package, they should start transferring assets–held in the dependent’s name–two or more years before college enrollment. Moving assets can become a minefield without proper planning and lead time. If the student has a Roth IRA, the money should not be withdrawn until after the financial aid form is filed. This is now easier to do since parents can use tax returns from two years earlier, in addition to filing for financial aid in October instead of January.