Financial Aid and Retirement Accounts

Question: My husband and I are 54 and 53 respectively and want to increase our contributions to our TSP 401(K) plan and Roth IRAs. Our daughter, who is applying for September 2003 college admission, is also applying for financial aid. Is it wise to increase contributions to our retirement accounts this year? What are the pros and cons of doing this?

This response to your very good question begins with a giant disclaimer. It is difficult to give accurate, specific financial suggestions without knowing a lot more about your family’s situation and the colleges on your daughter’s list. Only a bona fide financial advisor who is privy to your personal information can give you advice that will help you make the best decisions. Moreover, college financial aid methodologies do vary from institution to institution. In other words, this free advice comes with a you’re-getting-what-you’re-paying-for caveat!

Now, having said all that, here are some thoughts: the down side of putting money into your 401K (we’ll get to the Roth in a minute) is that whatever money you are deferring goes into the financial aid formula as “untaxed income.” This could mean that your daughter will receive less aid than if the same amount was counted as taxed income. (One way or another, it still counts as your income. It’s not being “hidden” from the financial aid guys.) The other drawback to putting money into the 401K is that you will have less cash available to handle your expected family contribution to college costs.

On the plus side however, is that if you are at your peak incomes right now (maybe likely given your age group?), then you will be getting the top tax savings on retirement deferrals.

College financial aid officers rarely sympathize with parents who object to counting retirement deferrals as “income.” The good news, however is that most colleges do not count the accumulated retirement assets already in place in any financial need formula—just the income you’re putting in there now.

The main thing to understand is that money you are deferring in the years you are applying for aid is not hidden from the financial aid formula. In fact, it is counted heavily since it is not offset by taxes.

Roth IRAs are different because they are for education. Those amounts in a given year are not usually counted as income but as an asset. That is an advantage because assets don’t go to the bottom line the way income does. So the Roth deferrals will not reduce your eligibility for need-based aid (or the amount you will probably receive) as much as the 401K deferrals. Additionally, the Roth monies can be used to pay for education without incurring withdrawal penalties, as is the case with the 401K.

Again, your best bet is to talk to a financial advisor, but hopefully this will give you some sense of how this confounding process works.