Does a Roth IRA Conversion Affect Financial Aid?

Joseph Meyer
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Benefits of the Conversion

If you already converted a traditional IRA to a Roth IRA, you should be very financially secure and ready to enjoy yourself in retirement. But if you’re just getting started with your retirement investment strategy, you probably converted at least some of your traditional IRA to a Roth IRA.

Remember that a Roth conversion does not have any income limits. This means that anybody with income can convert a traditional IRA account to a Roth IRA. Plus, if you don’t have any other source of income, your entire IRA is eligible for conversion without having to deduct any limit from it.

What advantage does the conversion have anyway?

Tax-Free Retirement Income that Can Be Withdrawn Anytime

People invest in a Roth IRA not only for tax-free accumulation but also to have a tax-free source of income in retirement. After you reach 59-1/2 years of age, you can withdraw any money in the Roth IRA anytime without having to pay any taxes on it.

It’s almost like a dream come true because you can withdraw any amount from your Roth IRA at any time without having to worry about paying penalties or taxes on it. Your IRA is your own money you can spend to enjoy life anytime you want without having to pay for the taxman to enjoy it with you.

Roth Conversion and Your FAFSA

Is it possible that your financial aid application will be frozen or rejected if you convert your regular IRA to a Roth IRA?

That’s what many investors fear, mainly because of tax inefficiency as one of the reasons people choose the Roth IRA over the regular IRA.

The good news is that converting your traditional IRA to a Roth IRA will not cause a problem for your financial aid application. But the reality is that it depends on how the assets are being managed.

Generally speaking, investors choose either the regular IRA or the Roth IRA based on the following:

The regular IRA is best for investors who believe their tax rate will be higher after retirement. A Roth IRA is best for investors who think that their tax rate may be lower after retirement … or who have no interest in ever touching their assets.

The tax rate is based on the individual not based on his/her children. For example, if this is your son’s year of college, you are responsible for reporting your assets on his FAFSA whether they’re in your name or in your Roth IRA.

Financial Aid Looks at More than One Year

Some of you might have heard that an IRA conversion can reduce financial aid when filing the FAFSA. However, when you dug into the U.S. Department of Education’s College Cost Estimate form to understand the exact impact of an IRA conversion, you found that it was inconsistent and only noted the effect for a single year.

While that’s not entirely inaccurate, the FAFSA’s treatment of your conversion is different than what you might expect. The FAFSA doesn’t look at what happened in the year of your conversion. Instead, the calculation is done on a four-year average.

What if Your Kids Are Young?

There are a couple of things you can do. The first thing that I recommended was to pray about it, but that’s not always the first thing on people’s list these days. Another important thing to make sure your children learn is how to save. Also, if I have a child that is going off to college in the next couple of years, I am going to show them how to invest wisely. For my children, that’s the whole point.

For the rest of my children, I want them to start saving and investing as early as possible. If you have children that are still young, start them off with a savings account that generates interest. Also, start them learning by talking to them about money. Don’t just give them an allowance and leave it at that. After they get an allowance, talk to them about how much money they’re getting and how long they’ll get to keep it. While you’re having this conversation, bring up a few things they could do with their money. Then start them off with one or two ways the could spend the money. It doesn’t even have to be something worthwhile. You could just say they could spend it on something like a Big Mac from McDonald’s.