Roth IRA Conversions And College Planning
Much has been written about the potential benefits, and tax liability, of converting an eligible individual retirement account (IRA) to a Roth IRA account in 2010. However, very little has been written about this decision and its impact on college planning. So it is important to note that the additional income resulting from a Roth conversion may or may not lower the financial aid eligibility of an account owner's college-age children, and may or may not impact the parent's eligibility to claim the American Opportunity Credit (also known as the Hope Tax Credit).
This article explores the ripple effects that a Roth conversion can have on the overall cost of college and the account owner's retirement savings. Planning insights are highlighted for the purpose of giving advisors a suggested track to run on when discussing Roth conversions with prospects and clients-a great way to tie college planning directly to investable assets. And the good news, as we shall see, is that Roth conversions can make sense for many account owners before their children enter college, while they are in college and even when they are finishing college.
The Roth Conversion Rules Prior to 2010, IRA owners whose income exceeded $100,000 were not permitted to convert their IRAs to Roth IRAs. However, in 2010 and beyond, the income limitation has been removed and IRA owners can now convert their eligible IRAs to Roth IRAs, regardless of income.
When converting all or part of an eligible IRA to a Roth IRA, the account owner is required to pay regular income tax on the entire amount of the conversion from a pre-tax eligible IRA account (Taxes on IRAs with after-tax contributions are calculated differently and non-spousal inherited IRAs are not eligible for conversion). Income from 2010 conversions can be reported on either the taxpayer's 2010 tax return or split between tax years 2011 and 2012 returns. This flexibility allows IRA owners to choose the reporting option with the greatest tax benefit.
The tax rules on distributions after a Roth conversion are slightly different from those of non-conversion Roth IRA accounts. One of the biggest differences is that account owners under age 59½ are required to hold the converted Roth account for five years before they can take any distributions without a penalty, providing that an exception does not apply, like college tuition, death, disability, etc. With a regular Roth account, as long as the account owner holds the account for more than five years, the account owner can at least take his/her contributions (basis) out before age 59½ without a penalty. There is no holding period for tax-free and penalty-free distributions from Roth IRAs that are converted after the account owner's age of 59½.
College Financial Aid Rules Expected family contribution or EFC is the minimum amount a family is expected to pay toward the cost of college, and is primarily based on the assets and income of the parents and student. A student's eligibility for need-based financial aid is determined by a simple need analysis formula that subtracts the student's expected family contribution ( EFC ) from a college's total cost of attendance to determine financial need (cost of attendance - EFC = financial need). If a student's EFC is less than a college's cost of attendance then the student qualifies for need-based financial aid.
Roth Conversion And College Aid Eligibility Roth conversions will create taxable ordinary income for the account owner in 2010, or split between 2011 and 2012, if reported over those two years. The conversion income will be reported as part of the account owner's total income on the college financial aid forms that need to be filed, if the account owner has a child entering or in college. The additional income from the Roth conversion will raise the student's expected family contribution ( EFC ), but the higher EFC may or may not exceed the cost of attendance of the college that the student is considering, or already attending. Therefore, the conversion income may or may not decrease the student's aid eligibility.
For example, parents with an adjusted gross income of $120,000, and two children will have an EFC based on income alone of about $25,000 per year with one child entering college. If that child attends a college that costs $20,000 per year, the child will not qualify for need-based student aid because the EFC is greater than the cost of attendance of the college (Cost - EFC = Need or Eligibility). On the other hand, if the parents decide to convert $80,000 of eligible IRA assets to Roth IRA assets, then the student's EFC will go from $25,000 per year to $52,000 per year. All the additional income does is raise their EFC further above the cost of attendance. So it doesn't impact the student's aid eligibility because the student is already not eligible.
Conversely, if the student is attending a college with an annual sticker price of $50,000 per year, then the $80,000 of Roth conversion income referenced above will definitely reduce the student's aid eligibility because the conversion income will drive the EFC up to $52,000 per year, which is more than the college's cost of attendance ($50,000 cost - a $52,000 EFC = $0 of aid eligibility). However, it should be noted that if the student is eligible for aid, there is no guarantee of exactly how much aid the student will receive from the college or what form of aid it will be (student loans, work-study, scholarships or grants). So you have to think about college aid eligibility with that in mind.
Roth Conversions And The American Opportunity Credit When it comes to college, there is financial aid and what we call "tax aid." Tax aid primarily refers to the American Opportunity Credit (otherwise known as the Hope Tax Credit) that taxpayers can claim on their federal tax return when paying for qualified tuition expenses. For many families, tax aid is more certain than financial aid because if they are eligible for it, they get it. Remember, if a student qualifies for need-based financial aid, there is no guarantee that the college will "meet" 100% of the student's financial need, or if the aid will be in the form of grants or student loans. Fortunately, the American Opportunity Credit (also known as the Hope Credit) is worth up to $2,500 per year per student.
The income phase-out to be eligible to claim this tax credit is $180,000 of modified adjusted gross income (MAGI) on joint tax returns. It is partially phased out between $160,000 - $180,000, and it is completely phased out for incomes in excess of $180,000.
Continuing with the example above, if the parents do not do a Roth conversion their income will remain at $120,000 per year and they will qualify for the American Opportunity (Hope) Credit. If they do a conversion, their income will swell to $200,000 and they will be phased-out of eligibility to claim the tax credit. Therefore, the decision to make a Roth conversion should consider the impact on both financial aid and tax aid.
Planning Opportunities If the student does not qualify for need-based aid and the parents can convert an amount of regular IRA assets to a Roth without becoming phased-out of eligibility for the college tax credit, then a conversion may be ideal because it will not impact aid eligibility and the tax credit can help offset the federal tax on the conversion income, dollar-for-dollar up to a maximum of $2,500 per year per child enrolled in college.
If the student doesn't qualify for need-based financial aid and the parents are already phased-out of eligibility for the tax credit, then the conversion decision goes back to being purely focused on issues of taxation and what assets to use to pay the tax on the conversion income. In other words, it has no impact on college funding.
If the student does qualify for need-based aid and the parents are eligible for the tax credit, then further consideration of a Roth conversion is warranted, with attention paid to the potential loss or reduction of financial aid and/or tax aid. However, even in this situation there is a planning opportunity. Consider the following example of an account owner with a child that has completed the spring semester of her junior year in college.
To apply for financial aid for her senior year of college, the 2010-2011 academic year, she would have had to complete the financial aid forms before the end of June 2010, and she would have had to report her parent's income from 2009 on the aid forms. Therefore, since she will be finishing college in 2011, and will not be applying for financial aid again, the account owner can make a Roth conversion in 2010 and it will not affect the student's need-based financial aid eligibility.
Conversely, for those parents whose children are a few years away from entering college, the question of a Roth conversion becomes one more focused on how the parent(s) will pay the tax on the conversion income and if it makes sense long-term for retirement. But there are tax and college planning considerations too. It is widely accepted that the best way to pay the tax on the conversion income is to use dollars from outside of the Roth account, thus allowing those tax-favored Roth dollars in the account to continue to grow.
Going back to the financial aid calculation for a moment, regular taxable assets sitting in stocks and bonds, mutual funds, savings accounts, etc, are counted against the family for aid purposes. So by doing a Roth conversion a few years before completing the college financial aid forms (the FAFSA and CSS Profile), and using some of the parent's assets that would have to be reported on the aid forms to pay the tax on the conversion, you can kill four birds with one stone.
- It generates the conversion income before the student files for financial aid, so it won't raise the student's EFC.
- Using the parent's assets to pay the tax on the conversion income reduces the amount of the assets that the family has to report on the financial aid forms. So it may also reduce the student's expected contribution, and thereby increase aid eligibility. However, you must remember that the family still needs to pay for college, so you shouldn't plan to use the parent's assets to pay the tax on the conversion income if they need those assets to pay for college.
- The conversion income will not occur during the college years, and thus will not reduce the parent's eligibility for the Hope tax credit if they would otherwise qualify.
- This strategy uses dollars from outside the Roth account to pay the taxes on the conversion income, so the dollars in the Roth can continue to grow on a tax-favored basis.
Furthermore, should the parents choose to do so, they may take distributions from their Roth conversion account to pay for qualified college tuition expenses without a penalty, even if the account owner is under age 59½ and has not had the conversion account for more than five years. This is because payment of qualified higher education expenses is one of the exceptions in the premature withdrawal rules that govern IRA and Roth IRA accounts.
"Even if you are under age 59½, if you paid expenses for higher education during the year, part (or all) of any distribution may not be subject to the 10% additional tax. The part not subject to the tax is generally the amount that is not more than the qualified higher education expenses (tuition, fees, books, room and board) for the year for education furnished at an eligible educational institution (any college, university, vocational school or other postsecondary educational institution eligible to participate in the student aid programs administered by the U.S. Department of Education). The education must be for you, your spouse, or the children or grandchildren of you or your spouse." Source, IRS publication 590
Conclusion While there are many factors that should be considered when deciding whether to do a Roth IRA conversion, some of the benefits can include greater long-term tax savings, no required minimum distributions after age 70½, and potentially lower estate taxes. The main points to consider are below:
- If the account owner has or will have children in college
- If the children are or will be eligible for need-based financial aid
- If the parents are eligible to claim the American Opportunity (Hope) Credit
- If there are dollars to pay the tax on the conversion income from outside of the Roth account
- The possibility of an increase in the account owner's tax bracket in the year of conversion
- Estimated future tax rates
- The timing of future distributions from the converted Roth account
- The impact of conversion income on those receiving Medicare and Social Security benefits
- The potential impact of the alternative minimum tax ( AMT )
- Age of the account owner at the time of conversion
- The flexibility to re-characterize the converted Roth assets and recoup the taxes paid
There are many advantages to converting an IRA account to a Roth IRA, but the conversion decision needs to be made with respect to other areas of the account owner's financial planning, especially those with college-age children.
Taking into consideration the insights and strategies shared above, many account owners may be able to convert their eligible IRA account to a Roth IRA, while also maximizing tax and financial aid for their college-age children. Ultimately, through overall lower college costs, and the potential for tax-free growth in a Roth IRA account, the account owner may have more wealth at retirement and could even leave a greater inheritance to loved ones.
Troy Onink and Bernard Whalen are the CEO and president, respectively, of Stratagee, a provider of college planning content, services and software. Stratagee is the developer of the Smart Search software that advisors can use to determine where a student may be able to Get Into College and Get Aid®. The firm's soon-to-be-released YBS software helps advisors deliver Your Best Strategy® to pay for independent school and college. Please visit www.Stratagee.com for more information.
Financial Advisor magazine reaches 90,000 financial planners and investment advisors through its print publication and its Web site . It also publishes FA green , for advisors interested in socially responsible investing, and Private Wealth , for advisors targeting the ultra high-net-worth market.