Roth Conversions, IRA Contributions, and College Financial Aid

[DoubleDown]

I'm guessing there are quite a few people here who may be in a similar situation, and I'm wondering what you've concluded. There's a tradeoff between Roth conversions, lowest possible taxes, and financial aid for college-bound kids. I've gone through calculations on lots of different scenarios, and I've concluded the best thing for us is to not do Roth conversions, and not do anything else special at all. Obviously it's highly a case of "YMMV" but what about you? Have you gone through the tradeoffs and found an optimal path?

Here's a basic graphic of the impacts, and they all work together (or more accurately, against each other). I can provide more context or details if anyone is interested:

Roth Fact 1:  Roth Conversion ==> Pay some lower taxes now (or $0 if your income is low enough) ==> Withdraw money tax-free 5+ years later

Roth Fact 2:  Roth Conversion ==> Higher AGI ==> Less college financial aid

Roth Fact 3:  Roth Conversion ==> Higher AGI ==> Really screw your chances for "automatic zero family contribution" or "no assets simplified test" for financial aid

Trad. IRA Fact 1:  Traditional IRA contribution ==> Lower taxes now ==> Tie up even more stash until old age ==> Pay taxes later on withdrawals (plus 10% penalty for early withdrawals)

Trad. IRA Fact 2: Traditional IRA contribution ==> Lower AGI ==> More college financial aid

Trad. IRA Fact 3:  Traditional IRA contribution ==> Lower AGI ==> Greater ability to qualify for "automatic zero family contribution" or "no assets simplified test" for financial aid

Taxes Fact 1: Qualifying for "simplified no-assets family contribution" for financial aid ==> Must earn less than $50k AND file a 1040A or 1040EZ ==> No itemized deductions ==> Higher taxes (for us, at least)

NO Roth Conversion Fact 1:   No Roth Conversions ==> No additional taxes now ==> Pay taxes on withdrawals later ==> Pay additional 10% penalty for withdrawals before age 59.5 ==> More college financial aid eligibility

Like I said, I went through all these calculations and decided it's best to do nothing at all, and just take the 10% penalty on IRA withdrawals later on. That's still a pretty low amount to pay overall, and converting to Roth now will really cost us in taxes now plus harming financial aid qualification for my three kids. I've also found that trying to jump through hoops to be able to file a 1040A is near impossible, and will cost us dearly in itemized deductions. Plus early retirees who sell investments to be able to live on will get a 1099B, which means you MUST file a 1040. So we'll just do as we always do, no hoops to jump through trying to maximize everything. Good news is it's the easiest choice; I'm all about doing nothing when I can :-)

[sol]

It's been a while since I dug into the details, but I seem to recall that the automatic zero EFC on the FAFSA was cutoff at $50k/year of income (plus free and reduced price lunch program) in your federal tax return regardless of family size.  Otherwise the cutoff is only 20k.   That's hard to meet if you are still carrying a mortgage.

So for early retirees who can live on less, and have no other income, you should be able to do annual Roth conversions of up to $50k without losing the FAFSA benefit.

That plan is complicated by your age (fafsa exclusions are based on parent age), rental income, capital gains, having multiple kids in college at the same time, and where your kid is applying (because different schools use different financial aid metrics in addition to the fafsa).

Also keep in mind that your previous years retirement contributions will be counted as income, even though your retirement assets won't.  In my case, it will be the income test that kills us.

But is it even worth it?  If you have to sell a rental property that earns $10k/year in cash flow and equity paydown in order to qualify for zero EFC fafsa and get $10k/year in subsidized federal loans that will have to be paid back anyway, I think you should keep the rental.  It doesn't make sense to give up thousands in earnings on real estate in order to save hundreds in interest on deferred loan payments.

Your time is probably better spent helping your kid study for the psat and then applying for private scholarships.  Smartypants kids still go to college for free.

[teen persuasion]

We've been filing the FAFSA since 2008, and I've been very attuned to the gradual changes  in details.  It used to be relatively easy to stay under the Auto EFC =0 limit when it was $29k or $30k or $31k AGI.  Then it was retroactively changed from $32k to $23k.  That was a bit harder target to reach for a family of 7, but at that point we still essentially hit zero EFC via the calculations.  We did qualify for the Simplified Needs Test , with AGI <$50k, so no assets needed to be reported, but even if they did the asset protection amount was a reasonable size for our EF, maybe around $30k.  Then the asset protection chart took a nose dive, too; I was shocked when it was under $6k I think.  That was "adjusted", but it is still under $20k for us (as we move up the age part of the chart).

We have to file 1040 due to our HSA, but until last year we qualified for reduced lunches.  We are now down to one kid at home, 2 in college, 2 out.  It was the drop in family size, with a bit of income increase, that ended the reduced lunch loophole for us.  The way the FAFSA rules are written, being eligible for reduced lunches in the student's senior year of HS grants 3 years of eligibility - the reduced lunch school year straddles 2 calendar years, at least one of which will cover 3 FAFSA years.  So we are approaching uncharted territory (for us) when DS4 does his senior year FAFSA.  He's a freshman now, and was caught in the switch to prior-prior year tax reporting, so the relevant tax years for him are 2015, 2015, 2016, 2017.  Then we'll have 3 years w/ no FAFSAs, and begin again for DS5 (2021-2024 tax years).  He will appear to be an only child, completely changing the calculations.  I wonder how the formulas and limits will change as a few more years go by.  I don't like the current trends.

I have definitely decided to forgo Roth conversion during FAFSA years - conversions increase AGI, AND Roth withdrawals are added back to income, a double whammy.  I've been trying to figure out if we could get to the point of pulling the trigger on FIRE just in time to match DS5's first FAFSA, but I'm not sure, esp w/ the ACA subsidies up in the air.  That one year lost to the prior-prior switch was unexpected.  Another option is if DH retires but I continue in my part-time role, supplementing a bit from DH's 401k using the 55 rule.  There's an awful lot of things that need to line up just right.

[teen persuasion]

One possibly useful recent change: another eligibility trigger for EFC = 0 or SNT was added - received Medicaid.  We'd probably end up with Medicaid rather than subsidies at the appropriate AGI for EFC = 0 (and no conversions).  Too unclear at this point what that will mean in 2021, though.

[DoubleDown]

Then the asset protection chart took a nose dive, too; I was shocked when it was under $6k I think.  That was "adjusted", but it is still under $20k for us (as we move up the age part of the chart).
...
I wonder how the formulas and limits will change as a few more years go by.  I don't like the current trends.

I'm glad you mentioned this. I was disappointed to learn that the asset protection amounts haven't been updated since 1980-something, and the formula is tied to some economic indicator that is woefully out of date (like bond rates or something). It is so bad that in a period of only 3 years, the exclusion amount has been cut in HALF. The amount you can exclude is pretty laughable at this point; as a 50-year old, I get only a $21k exclusion for two married parents. If I was single, the amount would only be $12k. Imagine how piss-poor that would be, only $12k in assets as a 50 year old! WTF, that's basically an "emergency fund" at best, and anything beyond that is considered fair game.

Your time is probably better spent helping your kid study for the psat and then applying for private scholarships.  Smartypants kids still go to college for free.

Agreed. I did not mean to portray my OP as the most important thing being qualifying for financial aid. Really I just wanted to relate that I'm finding that many of the strategies we discuss here break down in practice, and that trying to jump through hoops to take advantage of them isn't worth it in the end. You mentioned, for example, being able to do Roth conversions of up to $50k and still qualify for the no-assets test. But that tends to break down quickly. For example, if you sell any taxable assets, you'll get a 1099-B and the no-assets plan is out the window. We got a refund of state taxes, like almost everyone does, and same thing: State sends you a 1099G, and you must file a 1040. I made a whopping $50 from authoring a book late in the year, and I got a 1099-MISC. Hello you-must-file-1040.

And in my case, my wife still works. Even though she doesn't earn a ton, it makes Roth conversions pointless. I really don't mean to portray it as complaining. I mean, the hassles of early retired or soon-to-be early retired millionaires! I just wanted to relate that things seem to have line up perfectly for the strategies to work, and I'm just passing on them.

[aluc18]

Does the Traditional IRA will get added back to AGI to calculate EFC?  If so, it won't help for qualifying college aid.

[seattlecyclone]

One possibly useful recent change: another eligibility trigger for EFC = 0 or SNT was added - received Medicaid.  We'd probably end up with Medicaid rather than subsidies at the appropriate AGI for EFC = 0 (and no conversions).  Too unclear at this point what that will mean in 2021, though.

That Medicaid thing could make a big difference. In order to qualify for these special financial aid formulas it's not enough to just be under the stated income limit. You also need to either be on one of several means-tested benefits programs, or not have to file the full Form 1040. For the latter option that means no taxable stock sales, no HSA contributions or withdrawals, no rental properties...the list goes on.

But at least here in Washington, the ACA exchange shoves kids on Medicaid if their family income is below $78k for a family of four. If you're going through the ACA for health insurance in Washington, if you meet the income test for the special financial aid formulas you probably also are going to have your kids on Medicaid, making the 1040-A requirement moot.

[aluc18]

The income guideline for qualifying health coverage in Washington is based on the gross income or net income?

[seattlecyclone]

The income guideline for qualifying health coverage in Washington is based on the gross income or net income?

They use the MAGI as defined for the ACA: AGI plus excluded foreign income, non-taxable social security benefits, and tax-exempt interest.

[teen persuasion]

Does the Traditional IRA will get added back to AGI to calculate EFC?  If so, it won't help for qualifying college aid.

Yes, tIRA deductions (and traditional 401k contributions) are added back to calculate EFC.  But AGI (before add backs) is used to test for auto EFC = 0 and SNT (no assets reported).  So under the right circumstances tIRA deductions might be beneficial to your EFC.

HSA contributions thru payroll deductions are essentially invisible to EFC calculations (reduce AGI and not added back).  HSA contributions deducted on your tax return line 25 get added back, however.  Bizarre asymmetry.