The Roth IRA and Education Funding: Advanced Planning Strategies
Part 2 of a two-part series on how a Roth IRA can be used to fund your college savings.
Part 1 of this series discussed using a Roth IRA as a “Super 529,” a substitute for a 529 college savings account to fund college expenses for younger family members. In part 2, we will discuss some potential advanced strategies for Roth funding and financial aid applications.
After reading the first article, you probably understand that a Roth IRA can be used as a replacement for a 529 account. But what happens if you do not have any Roth funds to create your own ”Super 529”?
You can convert a traditional IRA to a Roth IRA if you are willing to have the amount converted taxed as ordinary income, which could raise your effective and marginal tax rates. There may not be a good time to make this conversion during your working career, but potentially lower-income years, such as transitional years between jobs or in retirement, could provide an opportunity. (There was a loophole that would allow someone under age 59½ to execute a Roth conversion and then immediately take out their “contributions” tax-free. However, the IRS had since instituted a five-year buffer between conversions and distribution for those under 59½, lest you incur taxes and penalties.)
Another option to build up a Roth balance is through any after-tax contributions in your 401(k). Before 1987, contributions made to a 401(k) were not tax-deductible. That changed in 1987, when only those contributions that were above an annual IRS limit were considered non-deductible. Your 401(k) provider will keep track of these amounts, which are separate from any after-tax Roth contributions you may have made. Upon retirement, these after-tax amounts must be returned to you at the time of your final rollover, at which point you have several options:
- Receive the amount tax-free
- Apply the amount to the basis of your company stock in a net unrealized appreciationtransaction
- Roll the after-tax amount directly into your Roth IRA
If the latter is chosen, you can use those after-tax amounts, which can be substantial, in combination with any Roth 401(k) rollover amounts and existing Roth IRAs to immediately boost your Roth IRA balance. Whether this is the right choice will vary among retirees, but it is a little-known rule of which you should be aware.
Lastly, we should discuss how assets saved for college could affect financial aid. If a student is claimed as a dependent, the claimer’s assets are counted against the student on the Free Application for Federal Student Aid (FAFSA), whether it’s in a 529 plan, Roth IRA, or any other type of college savings account. It is an advantage for a grandparent who does not claim the student as a dependent to be the owner of the college funds because those assets will not have any impact on the initial application. Once funds are used by the grandparent to pay for college, the income will count against the FAFSA application the next year, so this might only benefit the first year. This strategy will not apply to everyone, but knowing about it can help parents and grandparents structure their accounts appropriately.
Determining the best way to save for college can be daunting. Though Roth IRAs are preferable to 529s in certain cases, 529s are still a very powerful education-savings tool. If you have questions about how best to plan for college, please feel free to contact us – we’d be happy to sit down with you and talk through your options.
**While Baird does not offer tax or legal advice, our Financial Advisors regularly work with clients' attorneys and tax professionals to help ensure that all phases of wealth management are addressed
Click here for Part 1 of this two-part series, in which we discuss the basics of using a Roth IRA for education funding.