Roth IRA Conversion Opportunity in Year of College Graduation

A small amount of tax planning during your college years can significantly influence your financial aid package and give your retirement fund a graduation gift! It takes some discipline and flexibility to make it work, but it’s a win-win in the end.

The FAFSA tax

It starts with taking a close look at the FAFSA (Free Application for Federal Student Aid). Student income below a certain level (approximately $5,750 in 2011-2012) is excluded from what I call the “FAFSA tax.” The FAFSA formula assumes that 45.7% of any earnings above that will be spent towards the coming year’s college expenses—the Expected Family Contribution (EFC). For every dollar your EFC goes up, your Pell grant will go down (unless you’re off the scale on one end or the other). So if you’ve already earned $5,750 for the year and your wage pay for that summer job is $100 per day, $45.70 of it will go towards college expenses, reducing your Pell grant by $45.70 for each extra day you work.

I don’t know about you, but I’d rather get the extra $45.70 in grant funds than flip burgers for what amounts to half pay. One thing you might do is stop work when you see you’re approaching the $5,750 mark and spend the rest of the summer hiking the Appalachian Trail or doing volunteer social work (which looks better on your resumé than burger-flipping, of course). You might even plan to earn the year’s quota of income through part-time work while school is in session so that you can take the whole summer off back-packing through Europe with your roommate.

Suppose you’ve already earned more than the magic dollar amount for excludable income, or just can’t stand the thought of quitting. Here’s how to shelter the “excess” income from the FAFSA tax: Put the rest into a traditional (non-Roth) IRA, which increases your tax refund because it is tax-deductible. You can’t access it until retirement (bummer!), but it lowers your AGI, which is the amount the FAFSA looks at. If the AGI were higher, it would simply bid up your EFC (expected family contribution) resulting from the FAFSA and decrease the amount of Pell grant money you are eligible for.

I haven't been able to verify this, but I believe that some colleges take the liberty to add any traditional IRA contributions back onto the AGI. If your school does that, it ends up being counterproductive. You might want to inquire about that policy anonymously before counting on your traditional IRA to adjust the FAFSA as it does your IRS Form 1040.

Most students have a one-year window of opportunity to convert funds tax-free from a traditional IRA to a Roth IRA. But before discussing this hidden window, we need to understand the basic difference between the two types of IRAs.

A traditional IRA is "tax-deferred," in that a person will eventually have to pay income tax on it, whereas the Roth IRA is “after tax. At any time, a traditional IRA can be converted to a Roth IRA by paying the income tax up front. That usually involves some guesswork and what-if scenarios about the future. But students have a one-year loophole when the usual difference between the two types of IRAs may not matter.

The year you stop attending college or grad school, three things come together to give you a unique opportunity:

1. Your income will likely be considerably lower than in upcoming years. You may only have worked half of the year, or even at low wage before finding a career-track position.
2. You still had those huge tuition expenses for the first half of the year, which means that you still get a nice fat Tuition and Fees deduction or a credit for the American Opportunity or Lifetime Learning credits.
3. You will not be completing the FAFSA again, so there’s no need to try to make your AGI as low as possible.

Low income from #1 above, plus huge deductions or credits from #2 above, means that you probably won’t be paying any income taxes. All Federal income tax that was withheld will be refunded. In fact, you could probably earn a few thousand more without changing the bottom line of taxes. There’s the opportunity! If you’ve got any traditional IRA, convert it to Roth—converting it from pre-tax to after-tax without actually paying that tax out of pocket. If you’ve got a lot in your traditional IRA, you might not be able to convert the whole thing before you hit the threshold where you start paying tax. Adjust the numbers—up and down—until you find the optimum amount you can convert and still remain just below the amount where you would be taxed.