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Roth Conversion Can Hurt College Aid

This has been a big year for Roth IRAs. For the first time, anyone may convert a traditional IRA to a Roth and secure tax-free payouts in retirement. But a conversion, which adds to your taxable income, could affect your personal financial situation long before you retire. It might even ruin your child’s chance to qualify for college financial aid.

You probably already know the benefits of a Roth IRA. Whereas income from a traditional IRA is taxable, retirement distributions from a Roth in existence at least five years may be completely tax-free. That’s a tempting advantage, but before this year, the opportunity to convert to a Roth was available only in a year in which your modified adjusted gross income didn’t exceed $100,000. But when 2010 began, that income ceiling disappeared. And though you’ll owe income tax on the amount you convert to a Roth, a special one-time incentive for conversions made this year gives you the option of splitting the taxable income evenly between the following two years, 2011 and 2012.

Many factors could affect whether you choose to convert your traditional IRA to a Roth. Your age, whether you expect a higher or lower tax rate during retirement, and whether you have non-IRA funds to pay the taxes all could play a role. But if you have children who will be in college during the next few years, there may be another consideration: eligibility for financial aid.

Whether a student qualifies for need-based aid depends on the difference between the cost of attending the school and the “expected family contribution” (EFC). If the school’s cost exceeds the EFC, the student generally qualifies for aid. But the income resulting from a Roth conversion could push up your EFC and make your child ineligible for aid. For instance, suppose it will cost your child $40,000 to attend college next year, but a 2010 conversion adds to your income in 2011 and increases your EFC from $35,000 to $60,000. That could shut out your child from aid.

A Roth conversion could also affect eligibility for education tax credits. The maximum federal American Opportunity credit (formerly the Hope credit) is $2,500 for 2010. But this tax credit begins to phase out for joint filers with an adjusted gross income above $160,000 ($80,000 for single filers). Here, too, a Roth conversion could push you over the limit in 2010 if you choose to realize all the taxable income this year—or it could affect eligibility for a credit in 2010 or 2011, if you opt to defer the conversion income. A similar dilemma applies to the maximum $2,000 Lifetime Learning credit.

Depending on your situation, you might decide to forego a conversion in 2010 or reduce the amount you convert. We can help you figure out your best approach.

This article was written by a professional financial journalist for Legend Financial Advisors, Inc. and is not intended as legal or investment advice.


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