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Liz Weston: Conversion from 401(k) to Roth IRA could affect student financial aid, tax bill

Dear Liz: I have been contributing to my young adult children’s Roth IRAs for the past few years so they can start saving for retirement. My oldest son just quit his first job to go back to grad school. Since his income will be low this year, I advised her to invest her defined contribution plan with his former employer in her Roth IRA to consolidate his retirement savings. Will this conversion affect the maximum amount I can contribute to your Roth beyond the usual maximum contribution rules?

Reply: A conversion could do more than affect your ability to contribute to a Roth. It could also inflate your tax bill, reduce your eligibility for financial aid, and affect any health insurance subsidy you may be receiving. A conversion might still be a smart move because Roth IRAs offer tax-free withdrawals in retirement, but she needs to understand all the implications before taking his advice.

The amount your daughter converts from her 401(k) or other defined contribution plan would be considered a taxable distribution and treated as income. That could affect her eligibility for tax breaks, such as education tax credits and Affordable Care Act subsidies, as well as her ability to contribute to a Roth. (In 2023, an individual’s ability to contribute to a Roth is phased out between modified adjusted gross income of $138,000 to $153,000.)

In addition, to be eligible to make a contribution, she must have earned income at least equal to the amount she (or you) plans to contribute. Distributions from the retirement plan are not considered earned income, so you would need wages, salary, tips, bonuses, commissions, or self-employment income to qualify.

The conversion could affect your financial aid in future years. Federal aid calculations are based on tax returns from two prior years, so your 2023 tax return could affect your aid if you are still in school during the 2025-26 academic year.

Also, you need to figure out how you would pay the tax bill on the conversion. Converting a regular retirement account to a Roth might make sense if someone expects to be in a higher tax bracket later, but the math starts to unravel if the retirement account itself has to be raided to pay the tax.

Your daughter should consult a tax professional who can review her situation and provide personalized advice.

Liz Weston, a Certified Financial Planner, is a personal finance columnist for NerdWallet. Questions can be sent to 3940 Laurel Canyon, No. 238, Studio City, CA 91604, or by using the “Contact” form at asklizweston.com.

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