When you're paying for college, the more financial aid you qualify for, the better. Anything that lowers how much help you can receive is bad news. If you're contributing to an IRA, it's not going to make much difference to your financial aid package. If you decide to take money out of the account, that will have more of an impact.
Money you contribute to a traditional IRA doesn't show up on your taxes. It does, however, show up when colleges crunch numbers to figure your income. If, say, you and your spouse have an adjusted gross income of $90,000 but each contribute $5,500 to your IRAs, that drops your AGI to $79,000. In the Free Application For Federal Student Aid, you report your AGI, but then you add back this year's IRA contributions.
FAFSA's formula for figuring aid takes into account how much you pay in federal and state taxes. One side effect of contributing to a traditional IRA is that as you don't pay income tax, your allowance for taxes goes down. This can lower your eligibility by 10 to 25 percent of your contributions: depositing $5,000 this year could translate into a $500 to $1,250 drop in the amount of aid. That's not an issue with a Roth as you pay taxes on Roth IRA contributions.
The good news is that whatever you put in your IRA last year or the year before is off the table as far as figuring financial aid is concerned. Normally you have to list your assets when you apply, including your cash reserves. When you have money in an IRA, however, those assets play no role in figuring what you can afford. If your parents are helping pay for college, both their IRAs and yours are exempt.
If you take any distributions from your accounts, that money will have an impact. Say you've contributed $25,000 to your Roth IRA over the past few years and decide to withdraw $10,000 this year for an emergency. There's no tax when you withdraw Roth contributions, but you have to include the money in your income when applying for aid. The same is true if you take the money out of a traditional IRA. If you can avoid taking the withdrawal until next year, you're better off.
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