The adequate funding of retirement accounts is an essential part of many clients’ financial plans. Clients generally receive a tax benefit for making contributions to accounts like traditional IRAs and 401(k)s, and the funds inside these accounts are able to grow tax-deferred until distributions are taken. With such substantial benefits, it should come as little surprise that, according to an Investment Company Institute report, the U.S. retirement market was nearly $20 trillion as of the end of 2012, more than half of which was made up of IRAs and defined contribution plans.
While the use of retirement accounts is a “no-brainer” for many clients, they can sometimes create hidden traps that both clients and advisors are unaware of and fail to plan for before it is too late. These potential traps include affecting a potential client’s (or client’s child’s) opportunities for financial aid, increasing the amount of Medicare premiums a client owes and causing clients to pay income tax on a greater percentage of Social Security benefits. Below, each of these issues is discussed further so that you can talk with clients about these potential traps now and avoid surprises later.
Student Aid
If you have a client with a child who is already in college or is approaching that age, chances are they’ve noticed the extravagant costs that have come to be associated with post-secondary education. In today’s world, a four-year degree at even the most affordable state-run colleges can easily run into the tens of thousands. It should come as little surprise then that clients and their children alike go to great lengths to seek out any financial aid for which they qualify. But have you ever thought about whether your client’s IRAs, 401(k)s or other retirement accounts might impact their (or their child’s) ability to get financial aid?
Well, thankfully there is some good news here. As you may already be aware, clients’ retirement accounts can generally be excluded from their assets when they are filling out the free application for federal student aid (FAFSA). This includes their IRAs and Roth IRAs, as well as any company sponsored retirement accounts.
It’s not all roses though. Although clients can generally exclude these accounts as assets on a FAFSA application, certain colleges and universities do look at these accounts when determining who qualifies for their own student aid programs. For instance, a college could offer its own scholarship opportunities or other tuition assistance programs on a needs basis. However, determining who is and who is not needy is up to the school for its own programs. This is something that should be discussed with clients as they and their children begin to narrow down their educational options, so they can be sure to find out the specific policies and procedures for each school on their radar.
Retirement accounts can impact student aid in another way as well. Although they are generally not included as assets on the FAFSA application, the application does ask for information regarding a client’s income. This income can be impacted when clients take distributions from their retirement accounts, including those related to Roth conversions. As a result, advisors need to make sure they factor in these potential non-tax additional costs before recommending clients with children in college, or close to college-age, make Roth conversions or take other taxable retirement account distributions.
Medicare Premiums
What in the world does your client’s IRA have to do with their Medicare premiums? Nothing, provided their money stays in an IRA. If they start taking taxable distributions from their IRA or other tax-deferred retirement accounts though, their IRA could suddenly have an awful lot to do with their Medicare premiums.
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