24 Apr Retirement distributions and financial aid don’t mix well

 Q. I have a senior in high school and a sophomore in college. I’m thinking about retirement — I’m 59 — but I’m not sure how my retirement, and taking distributions from my retirement accounts will impact financial aid. Is there a smarter way to take the money out?

A. You’re correct in your assumption that withdrawals from your retirement accounts can have an impact on your kids’ financial aid eligibility.

Even though you can begin drawing on your retirement accounts penalty-free once you reach age 59 ½, the distributions will be noticed by the financial aid gods.

“The Free Application for Federal Student Aid (FAFSA) considers both the income and assets of the parents and child in terms of the amount of financial aid a student may be eligible for,” said Charles Pawlik, a certified financial planner with Lassus Wherley in New Providence. “Although assets in qualified retirement accounts are not counted on the FAFSA in the calculation of the expected family contribution (EFC) towards college costs, distributions from retirement accounts are counted as income.”

Therefore, he said, taking distributions from retirement accounts has the effect of converting non-counted assets into counted income for financial aid purposes.

The FAFSA counts income more heavily towards the EFC than it counts assets, he said, so retirement plan distributions can have a significant impact on eligibility for need-based financial aid.

Let’s take a closer look at the formula to compute the EFC.

According to Savingforcollege.com, the EFC will consider:
• 20% of a student’s assets (money, investments, business interests, and real estate)
• 50% of a student’s income (after certain allowances)
• 2.6%- 5.6% of a parent’s assets (money, investments, certain business interests, and real estate, based on a sliding income scale and after certain allowances)
• 22%-47% of a parent’s income (based on a sliding income scale and after certain allowances)

Based on the last point — the parent’s income — and because an IRA or 401(k) withdrawal will be included as the parent’s income and part of their adjusted gross income number, there will be a significant effect on financial aid eligibility, said Brian Power, a certified financial planner with Gateway Financial in Westfield.

“Unfortunately, there are no `smarter ways’ to withdraw money from retirement accounts with the exception being if you take the withdrawal from a Roth IRA,” Power said. “The withdrawals of a Roth IRA are tax-free as long as you withdraw the money after age 59 1/2 and have had the money in the Roth IRA for at least five years.”

Power said another strategy is to borrow the money from your 401(k) while you’re still employed. Many plan sponsors allow for participants to borrow up to half the balance of their 401(k) up to a maximum of $50,000, he said.

“It wouldn’t be counted as income, but someone would have to eventually pay the money back or the loan would convert to a withdrawal and become taxable income,” Power said. “So a strategy may be to take the 401(k) loan and pay back the loan payments until your youngest child no longer needs to apply for financial aid and at that point you can stop paying the loan back.”

If you have funds available in savings accounts and/or non-qualified taxable investment accounts that can be used to meet your needs for a period of time, Pawlik said it may be beneficial from a financial aid perspective to consider drawing on these funds first versus taking distributions from retirement accounts while your children are in college.

“Dividends, interest, and capital gains generated within non-qualified investment accounts are counted as income for financial aid purposes, however withdrawals from these accounts do not count as income on the FAFSA like withdrawals from retirement accounts do,” he said.

In addition, you may be able to utilize investment losses to offset capital gains generated from the sale of appreciated investments in your non-qualified investment accounts. Pawlik said up to $3,000 in capital losses can also be applied against ordinary income in a tax year, potentially further reducing reportable income on the FAFSA.

Furthermore, savings and non-qualified investment account assets are counted towards the EFC for financial aid purposes, so using these assets for living expenses while your children are in college may also reduce the amount of assets that are reportable on the FAFSA in future years, he said.

“In this way, taking withdrawals from savings and non-qualified investment accounts may give you the flexibility to better manage the overall income and assets that are reportable on the FAFSA and lessen the impact on financial aid eligibility, relative to taking distributions from your retirement accounts,” he said.

And because the FAFSA is based on income from the prior year, you could begin to take distributions from your retirement accounts once the FAFSA has been filed for your youngest child’s senior year without those distributions affecting financial aid eligibility for their final year in school, Pawlik said.

But before you start taking anything from retirement accounts, you need to make sure you will not run out of money before you die.

“The biggest risk I see in this situation is that this person is entirely too young to start taking money from their retirement accounts if they want it to last for their life time,” Power said.

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This story was first posted in April 2015.