To Convert or Not To Convert; How Does a Roth IRA Conversion Affect Student Aid? - Fastweb

To Convert or Not To Convert; How Does a Roth IRA Conversion Affect Student Aid?

Mark Kantrowitz

October 31, 2011

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.

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