4 Ways Smart IRA Planning Can Help You Pay Less for College
By Michael Branch
Ed Slott Master Elite IRA Advisor
With college expenses at some of the best schools now exceeding $60,000 per year, education related expenses are fast becoming 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. Below are three ways smart IRA planning can help you pay less for college.
1. Retirement Assets are Exempt from the EFC
When applying for financial aid, a family’s Expected Financial Contribution (EFC) is determined by a federal formula established after submitting the Free Application for Federal Student Aid (FAFSA) form. IRAs and other retirement accounts are exempt assets when calculating a family’s need for financial aid. A family can have an unlimited amount in an IRA or 401(k) with no impact on their EFC.
For example, two 50-year-old working parents can contribute up to $23,000 each into their 401(k). What’s more, if they qualify, they may also be able to contribute up to $6,500 each into their IRAs. A total of up to $59,000 in assets can be sheltered from the financial aid calculation in this way each year.
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.
2. Employer Contributions to Retirement Plans are Also Exempt from the EFC
Employee contributions to retirement plans get added back into the family’s EFC as untaxed income; however, employer contributions do not. Since employer contributions such as defined-benefit contributions, 401(k) matches and profit-sharing are not included in the financial aid calculation, some self-employed people may also be able to shelter significant assets from the financial aid calculation as well.
For example, a 50-year-old self-employed person 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.
3. Education Related Tax Credits
Retirement plan contributions also lower your adjusted gross income (AGI) and may help high-income earners qualify for education related tax credits. In 2014, the income phase-outs for the American Opportunity Tax Credit begin at $160,000 and end at $180,000 of Modified Adjusted Gross Income (MAGI) for married couples filing jointly. For the Lifetime Learning Credit, the phase out is applied on MAGI between $108,000 and $128,000 for married couples filing jointly. If a family has a MAGI 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.
4. Roth IRAs
Roth IRAs offer a unique 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 ½ 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. 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.
Roth IRAs may also be an effective way for kids to save money for their own college education. Kids with earned income from a job can contribute to a Roth IRA and ensure that the money stays in their name and is exempt from the financial aid calculation.
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.
People 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. Most families won’t qualify for need-based financial aid regardless of how much planning they do. Their income is simply too high. For many of these families, financial planning for college is more about reducing taxes and maximizing after-tax cash flow than receiving need-based financial aid or scholarships. IRAs and retirement plans are a great way to do this.
Other families may be in a position to reap significant need-based financial aid either from the government or the school they attend or both. Families with lower incomes, but high-net-worth could be good candidates for financial aid if their assets are positioned properly. Examples include widows, those who inherit assets, the self-employed and small business owners, and the temporarily unemployed.
A strong command of IRA planning strategies combined with knowledge and understanding of the financial aid system can help you pay less – sometimes a lot less –for your kids’ college education.
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