Roth IRAs and the FAFSA
When it comes to college funding, most families seem to be “in the middle.” They aren’t wealthy enough where college funding isn’t a concern and at the same time, they aren’t poor enough where the government will help pay for most, if not all, of their children’s college education.
Being in the middle means these families will most likely not be able to rely solely on need-based financial aid for college. Instead, they must put together a sound financial plan, so that saving for college doesn’t cost them when it comes time to complete the Free Application for Federal Student Aid (FAFSA).
As I’m sure many of you already know, the FAFSA calculates your Expected Family Contribution (EFC) based on both the parents’ and the student’s income and assets. Most of us really can’t control the income that is reported on our taxes each year, and thus the only real variable that we can control when completing the FAFSA is our assets.
The FAFSA does not count ALL your assets in its formula, however.
One of these non-assessable assets is the Roth IRA. It is technically a retirement asset, but it can be used for college education with no penalty or taxes if the account has been established for at least five years.
“I Make Too Much Money for a Roth IRA”
Many of you “in the middle” might say to yourself, “I make too much money to contribute to a Roth IRA.” If you are one of those people, you are both right and wrong at the same time!
What do I mean by that?
You cannot contribute directly to a Roth each year if your income exceeds the threshold ($137K for single filers and $203K for married filing jointly in 2019), but you can contribute indirectly to a Roth IRA via a backdoor conversion.
How Does the Backdoor Conversion Work?
There is no limit on how much and how many times you can convert or transfer funds from your Traditional IRA to a Roth. If you do that with pre-tax savings, however, the conversion will incur taxes.
Therefore, the strategy that I use and that I recommend to many families is to make non-tax-deductible contributions to a Traditional IRA and then convert those contributions almost immediately to the Roth IRA. There will be no tax deduction, but as long as the funds haven’t grown in the Traditional IRA (which is unlikely if you convert as soon as possible), there should be no taxes.
What are the Tax Implications?
If you already have a pre-tax IRA balance, however, there will be pro-rata taxation when converting new contributions to the IRA that then get transferred to the Roth via the back-door conversion.
For example, say I already have $6,000 of pre-tax savings in my Traditional IRA. I then contribute $6,000 this year but do not deduct that contribution on my taxes. When I convert that $6,000 of new money to my Roth IRA, the conversion will be 50% taxable. In other words, of that $6,000 that I converted to the Roth, only half, or $3,000 will not be taxed.
One way to avoid this pro-rata taxation issue is to rollover any IRA balance that you might have into your existing employer’s qualified retirement plan. If that is possible, you will effectively zero out your IRA account balance, so that now you can accrue only non-tax-deductible contributions which can be converted to the Roth free of tax.
How Does a Roth IRA Compare to a 529 Savings Plan?
Section 529 Plans
Section 529 Plans are excellent vehicles for college funding. In many states, you can receive a tax deduction or even a credit for your contributions to a 529 plan (click here for the details for your state). Your money will grow tax-deferred and can be withdrawn tax-free, as long as it is used for qualified education expenses—things like tuition, room & board, books, and mandatory supplies.
To top it all off, each parent can contribute up to $15,000 a year without incurring gift tax liability. When it comes to tax benefits, the 529 Plan is the pinnacle of college savings accounts—potentially tax-deductible, tax-deferred growth and tax-free withdrawals, as long as the money is used for qualified educational expenses.
Section 529 Plans are flexible in that you can transfer them to another family member if your child doesn’t go to school, but if you do not end up using the money for education expenses, you will pay federal income taxes on your earnings AND you will incur a 10 percent penalty on said earnings.
Where the Roth IRA shines, however, is in its flexibility. A Roth IRA can be used for expenses beyond the eligible education expenses delineated above. Perhaps you need access to that money for something other than education. Maybe your child decides college is not right for them, or your child goes to a less expensive school. You can use that money for retirement without penalty.
Remember also, the Roth is not counted as an asset on the FAFSA, unlike the Section 529 Plan.
All this being said, you are not getting the tax benefits of the 529 if you choose the Roth, nor can you contribute as much on a yearly basis. Furthermore, be aware that the Roth IRA is built for retirement. Although it CAN be used to pay for college, that doesn’t mean it SHOULD be. It can be risky to have a hybrid account like this, with college and retirement pulling at both ends.
As we say all too often in this business, find the solutions that align best with your own situation. Talk with your financial advisor and figure out what’s best for you.
Thanks for reading this post. We at the College Coach Funding Coach hope that this was both educational and helpful as you plan for college funding and beyond. Please feel free to reach out with your questions!
James L. Hicks, CFP, MBA, ChFC, CFBS, CLU