To Convert or Not To Convert; How Does a Roth IRA Conversion Affect Student Aid?
October 31, 2011
The Free Application for Federal Student Aid (FAFSA) bases eligibility for financial aid on total income during the previous tax year. For example, the expected family contribution (EFC) for a family filing the FAFSA on or after January 1 of the senior year in high school will be based on the income during the spring of the junior year and the fall of the senior year. If the Roth IRA conversion occurs before this year (i.e., in the fall of the junior year or earlier), it should not have any impact on eligibility for need-based financial aid. (Occasionally colleges will look at income in earlier years when there are unusual circumstances, such as income that changes significantly from one year to the next. But in most cases the income reported on the FAFSA is based only on the prior tax year.)
If the Roth IRA conversion occurs in a year that does affect aid eligibility, the family should ask the college financial aid administrator for a professional judgment review. The US Department of Education issued a Dear Colleague Letter (GEN-99-10) in February 1999 to clarify that college financial aid administrators may adjust income on the FAFSA to exclude the income that results from a Roth IRA conversion. The following is the relevant excerpt from the Dear Colleague Letter:
“One recent phenomenon that artificially increases income with potentially adverse impact on the financial aid applicant is the Roth IRA. Students from families who transfer funds from regular IRA accounts to Roth IRA accounts will typically see their taxable incomes increase, and this increase will reduce their eligibility for federal student assistance. Yet, these increases are on paper only – these families do not have additional income available for meeting educational expenses. Again, financial aid personnel are encouraged to review these cases individually and, where warranted, use their professional judgment authority to reduce applicable family income and taxes to the levels that would have applied without the Roth transfers.”
If the Roth IRA conversion will affect eligibility for the education tax benefits or other tax benefits, the taxpayer could make smaller partial conversions over several years instead of all at once. This may also save money by keeping more of the income from the conversion in a lower tax bracket.
But reducing the tax liability too much can also be problematic. The taxpayer should ensure that there is enough tax liability to offset the tax credit, since the Lifetime Learning tax credit is not refundable and the Hope Scholarship tax credit is partially refundable. Only 40% of the Hope Scholarship tax credit is refundable. To get the full $2,500 Hope Scholarship tax credit, instead of just $1,000, the taxpayer’s tax liability must exceed the amount of the tax credit.