Using Roth IRA to Lower Assets for Financial Aid

You have probably heard, but college is very expensive. Make that very, very, expensive. College is so expensive that even if you do pretty well with earnings and income, it can be hard to afford. In fact, having a higher income might actually make college harder to afford.

Financial Aid for Higher Income Parents

I’m going to make some assumptions here so that you know whether this is the right article for you. I’m going to assume that your child does well in school, has good SAT scores or ACT scores, and is applying to some higher tier universities. I’m also going to assume that your family income is in the six figures.

There are two main types of financial aid. The first type is merit based financial aid. Often called scholarships, this kind of aid is offered to students based upon some factor other than need. The second type of financial aid is need based financial aid. This is financial aid that is based upon how much money you and your parents have. More specifically, need based financial aid is based on how low your income and assets are.

Using Roth IRA to Lower Assets for Financial Aid 1
Someone remind me to get some pictures of Old Main next time on campus, so I have better photos for my college savings stories.

Need Based Financial Aid with Higher Incomes

Here is where it gets sticky. The cost of attending a university like Stanford University, for example, varies greatly based upon your income and assets. According to the Stanford financial aid website, if your gross family income is less than $75,000 the average scholarship and grant award is $82,356 resulting in a net cost of $4,118 per year. However, if you make between $150,000 and $175,000, that average scholarship and grant drops to $51,210 resulting in a net cost of $29,558. If you’re doing the math that means you’d need to pay somewhere in the neighborhood of $2,400 every month to cover one year of college. (Of course, these examples assume that the person making $150K has a certain amount of assets, but you get the idea.)

If you have a gross (before taxes) income of $150,000, you know that you don’t have $30,000 per year laying around, even if you’ve been saving a few hundred bucks a month in a 529 plan since your children were born. For starters, the taxes on $150,000 are around $6,000 with the standard deduction for a family of four filing jointly. Your health insurance isn’t free, plus you probably have a mortgage or a rent payment, and so on. The idea that you have $30,000 that you can just find somewhere in your budget isn’t realistic. If you are lucky, you have some money saved, but there is another catch.

Standard Financial Aid Formula

The standard financial aid formula is based upon something called the Expected Family Contribution (EFC). Beginning July 2023, they renamed it Student Aid Index or SAI because expected family contribution means you expect families to contribute that amount. Needless to say, there are differences of opinion on what a family should be “expected” to contribute. By renaming it something with no meaning, that problem goes away.

However, the basic formula remains unchanged. A student is expected to contribute 20% of their assets toward their college expenses. The parents are expected to contribute 5.6% of their assets. It is the parent part that trips up a lot of middle- and higher-income parents and ends up saddling their children with higher student loans.

Imagine, for example, the Smiths. The Smiths make $150,000 per year. As recommended by every financial advisor and publication on the planet, the Smiths have saved three months’ worth of income as an emergency fund. That works out to $37,500. It doesn’t matter that the money is a financially sound financial planning requirement and not an excess of party money. All parent assets are included in the 5.6% calculation Thus, the Smiths owe $2,100 per year in addition to whatever the expected contribution based on their income is.

If the Smiths have other money saved, like for a graduation, family trip to Paris, that counts against you.

Financial Aid and Retirement Accounts

Much like other legal situations, financial aid does not take balances inside of qualified retirement accounts into consideration as assets. This is in no small part due to the fact that forcing premature withdrawal from a retirement account could trigger a nasty tax problem.

Of course, most qualified retirement accounts have rules in place to make sure you end up using them for retirement. Penalties and income taxes on early IRA withdrawals or 401(k) distributions are not fun.

Hide Assets in Roth IRA

I don’t like the phrasing how to hide assets for financial aid, but it’s sort of what you are looking to do. Yes, a Roth IRA is a good way to remove some assets from consideration for financial aid, but there is always a catch.

In this case, the catch is that you can only contribute a certain amount to a Roth IRA, $6,000 in 2022 for standard contributions. Remember that you and your spouse can each contribute $6,000, so it is a total of $12,000 per year. If you are reading this account when your oldest child is a freshman, you can stash away almost $50,000. (If you are reading this when your oldest is a Senior, don’t feel bad. I did the same thing.)

A 529 plan allows for much larger contributions. Also, while withdrawing the after-tax contributions to the account are penalty and tax-free, withdrawals of earnings from a Roth IRA are subject to income tax, and add to your income, which means your expected contribution from your income will be higher.

Author – Brian Nelson

Brian is a former Certified Financial Planner (CFP) and financial advisor. He is also a father with children approaching college age. You can read Brian’s articles about parenting over on Undefeated Daddy, although after this whole paying for college thing, I might need to change the name 🙂 – Please be aware that this article was written in 2022 and rules may have changed since then. For specific financial aid questions contact the financial aid department at the school you attend, or intend to attend.

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