Q&A: How a Roth IRA rollover can cause unforeseen problems

Dear Liz: I have been contributing to my young adult children’s Roth IRA accounts for the past few years to get them started on retirement savings. My oldest just left her first job to go back to graduate school. Since her income will be low this year, I advised her to roll her defined contribution plan with her former employer into her Roth IRA to consolidate her retirement savings. Will this conversion affect the maximum amount that I can contribute to her Roth beyond the usual rules on maximum contributions?

Answer: A conversion could do more than affect her ability to contribute to a Roth. It also could inflate her tax bill, reduce her eligibility for financial aid and affect any health insurance subsidies she’s receiving. A conversion could still be a smart move because Roth IRAs offer tax-free withdrawals in retirement, but she should understand all the implications before following your 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, the ability for an individual to contribute to a Roth phases out between modified adjusted gross incomes of $138,000 to $153,000.)

Also, to be eligible to make a contribution, she must have earned income at least equal to the amount she (or you) plan to contribute. Retirement plan distributions aren’t considered earned income so she would need wages, salary, tips, bonuses, commissions or self-employment income to qualify.

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

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

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

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