<b>I am retired with no income from employment and a moderate amount
of investment income, $20,000 to $30,000 a year. I am contemplating a
partial conversion from my traditional IRA to a Roth IRA. Such
conversion is included in my adjusted gross income, but is not really
spendable income to support my son's education. If I make such a
conversion, would this adversely impact our eligibility for financial
aid for my son's college education? For example if I do a $200,000
conversion that might move my AGI from $30,000 to $230,000. Do I need
to avoid making Roth IRA conversions until my son graduates from
college? I am 60 and my son is a high school sophomore. If I wait
until he graduates from college, I will be age 67 and at that point a
Roth IRA conversion makes little sense.
— Allan J.
Since January 1, 2010, taxpayers have been able to convert a
traditional IRA into a Roth IRA regardless of income or tax-filing
status. Previously, Roth IRA conversions were restricted to taxpayers
with income under $100,000 and taxpayers who filed federal income tax
returns as married filing separately were also ineligible.
The main differences between a traditional IRA and a Roth IRA concern
the contributions and the distributions. Contributions to a
traditional IRA are made with before-tax dollars, while contributions
to a Roth IRA are made with after-tax dollars. Distributions from
a traditional IRA are taxable, while distributions from a Roth IRA
are not. (Note that distributions from a Roth IRA are tax free only if
the taxpayer is over age 59 1/2 and the account has been open
for at least five years.)
Converting part of a traditional IRA to a Roth IRA can provide a hedge
against tax increases. If the taxpayer's tax rate will increase in
retirement, a conversion can save money. Odds are likely that Congress
will increase taxes (or reduce tax breaks) in the future, given the
record budget deficits. The Bush Administration tax cuts account for
more than 40% of the budget deficit, making it likely that some of
these tax cuts will not be extended beyond their expiration in 2012.
Another benefit of a Roth IRA is the lack of a minimum required
distribution. If the taxpayer's children inherit the Roth IRA, they
will not be required to take distributions either. With a
traditional IRA, the taxpayer is required to take distributions at age
70 1/2.
But the conversion from a traditional IRA to a Roth IRA results
in taxable income that is included in the taxpayer's adjusted gross
income. (For 2010 there were special conversion rules that allowed the
taxpayer to pay the taxes over two years. In 2011 and later years, the
income from the conversion is reported in a single tax year.) Income
taxes are based on the amount of the conversion, including both
earnings and before-tax contributions. Any after-tax contributions are
assumed to be proportionally included in any distribution.
Thus converting a traditional IRA into a Roth IRA can bump the
taxpayer into a higher tax bracket. This could increase the adjusted
gross income enough to disqualify the taxpayer from a variety of tax
benefits, including the Hope Scholarship tax credit, Lifetime Learning
tax credit and the tuition and fees deduction. It can also affect
eligiblity for student financial aid.
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 October 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.
