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How Smart IRA Planning Can Help You Pay Less For College

02/26/2015 11:43 am ET | Updated Apr 28, 2015
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With college expenses at some of the best schools now exceeding $60,000 per year, education-related expenses are often one of the biggest obstacles many baby boomers face when saving for their own retirement. For many families, planning for a college education goes hand in hand with IRA's and retirement planning.

Retirement Assets are Exempt from the EFC

A family's Expected Financial Contribution or EFC is determined by a Federal formula after submitting the Free Application for Federal Student Aid (FAFSA) form. Typically, this is done in the winter or spring of a student's senior year of high school.

IRAs and other retirement accounts are exempt assets when calculating a family's need for financial aid. A family can have $1,000,000 or more in an IRA or qualified retirement plan with no impact on their EFC.

To lower a family's EFC and increase their potential to receive financial aid families should consider strategies to maximize contributions to their IRA, 401(k) and other retirement accounts. And they should fund those accounts before completing the FAFSA or other financial aid forms.

For example, a family with two 50-year old parents can put $6,500 into Roth IRAs for each parent and up to $23,000 each into their 401(k). A total of up to $59,000 in assets can be sheltered from the financial aid calculation in this way each year.

Employee contributions to retirement plans are factored into the family's EFC; however, employer contributions are not. In the example above, the $23,000 employee contribution to the 401(k) gets added back into the financial aid calculation as non-taxed income. The benefit of this strategy is not that the income is lower for purposes of qualifying for additional financial aid, but that the assets are removed from the financial aid calculation. In the case of a family with significant assets, maximizing retirement plan contributions can help shelter at least some of those assets from the calculation of need on the FAFSA form allowing them to possibly qualify for additional financial aid.

Tax Savings

Families may also benefit from the tax savings that come from making such a large retirement plan contribution. The tax savings can then be redirected towards college expenses. By contributing up to $46,000 ($23,000 from each parent) to their employer's 401(k) plan, a family can reduce their tax bill significantly. The tax savings can be used to help cash flow a chunk of college expenses. This may be an effective strategy for some families who may be good candidates for need-based financial aid, but have significant non-retirement assets.

Self-Employed

For self-employed people the planning opportunities may be even greater. A 50-year old self-employed person whose only employee is his spouse may be able to contribute up to $52,000 into an Individual 401(k) or other similar plan. The spouse-employee may be able to put away an additional $52,000. If they combine a 401(k) with a defined benefit plan, they may be able to put away even more.

The above strategy helps shelter assets from the financial aid system. However, since employer contributions such as 401(k) matches and profit-sharing are not included in the financial aid calculation, a successful self-employed individual with only himself and a spouse for employees may be able to make a significant employer contribution to a retirement plan such as a defined benefit or profit sharing plan. In this case, retirement plan contributions not only protect the retirement asset from the financial aid calculation, but also the income that produced the asset.

Other Benefits

Retirement plan contributions may offer other benefits as well. In 2014, the income phase-outs for the American Opportunity Credit begin at $160,000 and end at $180,000 of Adjusted Gross Income for married couples filing jointly. For the Lifetime Learning Credit, the phase out is applied on adjusted gross incomes between $108,000 and $128,000 for married couples filing jointly. If a family has an AGI that exceeds these numbers, increasing contributions to qualified retirement plans will lower the AGI, possibly enough to qualify for the tax credits described above. The maximum credit for the American Opportunity Tax Credit is $2,500; $2,000 for the Lifetime Learning Credit.

Roth IRAs

Roth IRAs offer an opportunity to save for both college and retirement at the same time. In fact, a Roth IRA may be a better college savings plan than more traditional investments like Uniform Transfer to Minors Accounts (UTMA), Coverdell Education IRAs or even 529 College Saving Plans.

Like traditional IRAs and other retirement accounts, Roth IRAs are exempt from the financial aid calculation. The principle is available tax-free. Earnings may also be tax and penalty free after age 59 ½. The 10% penalty on non-qualified distributions prior to age 59.5 is waived if the money is used for qualified education related expenses.

Consider this example: A 35-year old couple with a 6-year old child wants to save for college and retirement at the same time. They may be able to contribute up to $11,000 per year ($5,500 x 2) for the next 12 years. Up to $132,000 may be available tax and penalty free for college expenses. If the money is not used for college, it continues to grow tax-free for the couple's retirement. In addition, Roth IRAs offer more flexibility, more control, and better financial aid opportunities than many traditional college saving vehicles.

Roth IRAs may also be effective ways for kids to save money for their own college education. Most individuals who have earned income are eligible to contribute to an IRA, including minors. Kids who work can contribute to a Roth IRA and ensure that the money stays in their name and is exempt from the financial aid calculation. Like anyone else they can contribute up to 100% of their income or $5,500, whichever is less.

The downside to the above strategy, however, is two-fold. First, the earnings from a Roth IRA may be taxable if withdrawn prior to age 59 ½ and subject to a 10% penalty if not used for college. Second, principal taken from a Roth IRA may be considered "non-taxable income" when students fill out the FAFSA form possibly reducing financial aid benefits in the future. What's more, some private colleges and universities may consider the entire Roth IRA to be an asset that can be used to pay college expenses. While a Roth IRA can be a great strategy for some kids, you should consider the trade offs before making a decision.

Roth IRA Conversions

Taxable income from a Roth IRA conversion counts as income on the FAFSA form. Since the FAFSA looks at a family's income from the prior tax year, a family planning to receive need-based financial aid in 2013 may be wise NOT to convert an IRA in 2012. The income produced by a 2012 Roth IRA conversion will produce a higher EFC on the FAFSA form in 2013 resulting in reduced need-based financial aid benefits for some families.

For a family with students who plan to attend college after 2013, a Roth IRA conversion may be a great strategy for the reasons outlined above: the Roth Conversion IRA is an exempt asset on the FAFSA form, and the principle is available for college or other uses. Assuming an average annual return of 8%, a 47-year old parent of a 6-year old student who converts a traditional $100,000 IRA to a Roth IRA would have about $250,000 available tax free for college or other expenses when he turns 59.5. A younger parent would have $100,000 in Roth IRA principle that can be used for college or other expenses. Earnings could remain in the Roth IRA growing tax-free for retirement.

IRA Distributions

Distributions from IRAs and other retirement plans are treated as taxable income for tax purposes as well as for determining a family's need for financial aid. In a worst case scenario, if a parent liquidates an IRA to pay for college, he not only creates a tax liability that will make it even harder to pay for college, but he takes money out of an asset that was exempt from the calculation in the first place.

The 10% early withdrawal penalty is waived if the IRA distribution is used for college expenses. If a parent needs IRA money to pay for college, she might be better off taking loans and using IRA distributions to pay off the loans after graduation rather than liquidating the IRA to pay for school now. All too often, cash-strapped parents are tempted to liquidate IRA assets to pay college expenses. Not only does this increase their tax burden, but it may also decrease their eligibility to receive financial aid for college.

Summary

Families often equate financial aid and college planning with getting free money from the government in the form of Pell Grants and other types of need-based financial aid.

A strong command of IRA distribution planning strategies combined with knowledge and understanding of the financial aid system can help families pay less - sometimes a lot less -- for their kids' college education.

If you are a parent with a teen bound for college, be sure to consult a professional with experience in both financial aid and retirement planning before filling out your financial aid forms. Smart IRA and retirement planning can go a long away towards helping you pay less for college.

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