The decision to convert funds in a traditional IRA to a Roth this year is hardly a slam-dunk. To reach a well-informed conclusion, you must take the relevant factors into account. This can be especially tricky for some parents of college-bound children.
Strategy: Consider all the higher-education aspects. If you’re not careful, converting might do your family more harm than good.
A Roth IRA conversion results in extra taxable income that may affect eligibility for (1) need-based financial aid and (2) education tax credits.
Here’s the whole story: Unlike a traditional IRA, contributions to a Roth IRA are never tax-deductible. But other tax benefits are available on the back end. For starters, qualified distributions from a Roth in existence at least five years are completely tax-free.
Furthermore, you don’t have to take Roth distributions during your lifetime, as opposed to traditional IRAs requiring minimum annual distributions after age 70½. Therefore, a Roth enables you to preserve a larger nest egg for your heirs. On the downside, when you convert funds in a traditional IRA to a Roth, the portion representing deductible contributions and earnings is taxable at ordinary income rates.
Ever since the inception of Roth IRAs in 1998, conversions have been prohibited for anyone with a modified adjusted gross income (MAGI) exceeding $100,000. But the $100,000-of-AGI barrier has finally been removed, beginning in 2010. Now you’re free to convert without any income restriction.
Icing on the cake: If you choose, you can have the taxable income from a conversion in 2010 split evenly over the following two years. Depending on your expected tax brackets for the three years in question—2010, 2011 and 2012—this can be an advantageous tax move. Or not. If not, you can choose to pay the full tax liability in 2010.
So far, so good. But you can’t convert to a Roth in a vacuum. A 2010 conversion could cancel out eligibility for financial aid or eliminate a tax credit for higher-education expenses.
Problem No. 1: Eligibility for college aid
In simple terms, your child’s eligibility for need-based financial aid depends on the difference between the cost of attending the school and the “expected family contribution” (EFC). If the tuition exceeds the EFC, the child generally qualifies for the aid. On the other hand, no aid may be granted to your child if the EFC is greater than the school’s cost.
Have your child fill out the Free Application for Federal Student Aid (FAFSA) form if he or she will be attending college in the following year (i.e., beginning with the child’s junior year in high school).
We won’t get into the nitty-gritty here, but the EFC formula reflects the income and assets of the student and parents (as well as other factors like the number of children in school). Be aware that the income resulting from a Roth conversion can push the EFC past the point where your child would qualify for financial aid. The conversion income must be reported on the FAFSA and other forms required by the school.
Example: It will cost your child $45,000 to attend a specified college, but a conversion increases your EFC for the applicable school year from $40,000 to $80,000. Result: Your child no longer qualifies for the need-based financial aid at the chosen college.
Problem No. 2: Eligibility for higher-education credits
The tax law provides two credits for higher-education expenses. You can pick only one for the year for a particular student.
- The maximum American Opportunity credit (formerly the Hope credit) for 2010 is $2,500. This tax credit begins to phase out for joint filers with an MAGI of $160,000 ($80,000 for single filers).
- The maximum Lifetime Learning credit for 2010 is $2,000. This tax credit begins to phase out for joint filers with an MAGI of $100,000 ($50,000 for single filers).
Example: Your MAGI as a joint filer for 2010 is $150,000, but a Roth conversion increases it to $200,000. Result: You no longer qualify for the American Opportunity credit.
Note that the American Opportunity credit is scheduled to morph back into the less-generous Hope credit in 2011 unless Congress modifies the rules. Prior to 2009, the maximum Hope credit was $1,800 with the same phaseout range as the Lifetime Learning credit.
Tip: This doesn’t necessarily mean you should not convert to a Roth. Do an in-depth analysis.
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