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As a CPA who is now in law school, I've seen a lot of money left on the table. Hence, this post.

READ THIS FIRST: Everyone’s financial situation is unique. If you think you qualify for any of the below, make sure to check with a tax or financial expert.

IRS Circular 230 disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any tax advice contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any matters addressed herein.

Transfer funds in your IRA to a Roth IRA via a conversion

Potential Savings: Tens of thousands of dollars

Who this applies to: Most people with money in a non-ROTH retirement account in law school who
• Will have no income tax liability even if their income is added to their withdrawal (less than $26,300 as an individual, usually – depends on tuition paid as well)
• DISCLAIMER: If you think you qualify, you should see a financial adviser

Explanation: If your income is below a certain level then you can transfer money from a pre-tax retirement to a post-tax retirement account, without paying any taxes. This means that not only will your money grow tax free, but you will not pay any taxes upon retirement (unlike with the pre-tax retirement account). This can save tens of thousands of dollars depending on how much money you are making upon retirement. It also could prove beneficial if you need to withdraw money from your retirement account later.

Example: Take two students, A and B. Each student has $11,000 in an IRA from a job they held prior to entering law school. Near the end of the year, they estimate that their earnings for the year are $6,000 (welcome to 1L year :/). Student A converts $11,000 from their traditional IRA to a Roth IRA. A’s income for the year is $17,000 ($6,000 + $11,000) – they pay no income tax because of the lifetime learning credit and standard exemption. B pays no income tax either. A has $11,000 deposited into a Roth they open for the current year. A and B’s retirement accounts each grow at an average rate of 7% for the next 35 years. 35 years later, the value of the account is $127,442. Their marginal tax rates upon retirement are 20%. A will pay $0 in taxes, B will pay at least $25,488.

Lifetime Learning Credit

Potential Savings: Up to $2,000

This applies to: Most people with qualifying educational expenses and a lower income

Explanation: “For the tax year, you may be able to claim a lifetime learning credit of up to $2,000 for qualified education expenses paid for all eligible students. There is no limit on the number of years the lifetime learning credit can be claimed for each student.”
http://www.irs.gov/publications/p970/ch03.html
This means that an individual taxpayer for 2013 will not pay tax on the first $26,300 of income, assuming no unusual circumstances.

Example: Student A, an unmarried person who is no one’s dependent, and has no children, earns $26,300. They pay $20,000 in tuition in 2013. They get a personal exemption of $3,900 and a standard deduction of $6,100. Their taxable income is $16,300. Their tax is $1,999 (based on 2013 IRS tax brackets). They get a credit of $2,000 that offsets the tax. They have no tax liability.

You may want to pay up to $2,500 in student loan interest some years in law school

Potential Savings: Up to $525

This applies to: Anyone who will be in a marginal tax bracket of 10% or higher at the end of the year AND is paying some federal income tax (they have earnings that exceed the “lifetime learning credit” + personal deduction + standard deduction floor; generally $26,300+ for an individual taxpayer in 2013)

Explanation: By borrowing a little more and paying $2,500, the government is effectively subsidizing your loan with an additional “tax credit.”

Example: Take two students, A and B. Each student will have $50,000 of accumulated loans and $5,000 of accumulated interest at the end of the year. Near the end of the year, each student realizes that they will be in the 15% marginal tax bracket for the year (they both have 2L SAs paying $30,000+). A pays the interest and borrows an additional $2,500 (paying a $100 origination fee and keeping her loan balance equal to B). B does not pay the interest and does not borrow the additional $2,500. A saves $375 in taxes, and has $275 more than B after all the transactions are complete.


Retirement account and paying for law school

Talk to your financial adviser, though I usually recommend doing the transfer to the Roth over using the withdrawn funds to pay for school for a variety of reasons. This is more subjective and fact dependent though.

EdBurke wrote: Transfer funds in your IRA to a Roth IRA

Potential Savings: Tens of thousands of dollars

Who this applies to: Most people with money in a non-ROTH retirement account in law school who
• Do not have a full scholarship (pay some tuition)
• Have some self-employment income, wages or other qualifying income in the current year AND
• Will have no income tax liability even if their income is added to their withdrawal (less than $26,300 as an individual – usually)
• DISCLAIMER: If you think you qualify, you should see a financial adviser – this is complicated

Explanation: If you meet all of the qualifications (which most law students who meet the “who this applies to” test do) then you can transfer money from a pre-tax retirement to a post-tax retirement account, without paying any taxes or penalties. This means that not only will your money grow tax free, but you will not pay any taxes upon retirement (unlike with the pre-tax retirement account). This can save tens of thousands of dollars depending on how much money you are making upon retirement. It also could prove beneficial if you need to withdraw money from your retirement account later.

Example: Take two students, A and B. Each student is paying $40,000 in tuition for the year. Each student has $11,000 in an IRA from a job they held prior to entering law school. Near the end of the year, they estimate that their earnings for the year are $6,000 (welcome to 1L year :/). Student A withdraws $11,000 from their IRA. They pay $0 in penalties as they have education expenses that exceed the withdrawal. A’s income for the year is $17,000 ($6,000 + $11,000) – they pay no income tax because of the lifetime learning credit and standard exemption. B pays no income tax either. A puts $5,500 into a Roth they open for the current year and $5,500 into that same Roth as soon as possible (for either the next year or previous year, depending on when they make the withdrawal). A and B’s retirement accounts each grow at an average rate of 7% for the next 35 years. 35 years later, the value of the account is $127,442. Their marginal tax rates upon retirement are 20%. A will pay $0 in taxes, B will pay at least $25,488.

Why does someone need have income in order for a Roth conversion (not a transfer) to make sense? Income is not a requirement for Roth conversions. Also, I get that they need to pay some tuition to get the larger deduction and avoid tax liability on the conversion, but even someone paying zero tuition can benefit from this strategy.

Your example is also really confusing. Your overall point seems to be that a Roth conversion makes sense, and I agree with that. But the example has person A withdrawing money from his IRA rather than converting it to the Roth, and then making additional contributions, which have nothing to do with Roth conversions. I'm not sure if you're misunderstanding how this works or if you just need to clear up the explanation. In fact, now that I look at it again, it seems you think that A can only move $5500 from his IRA to his Roth each year, which is just wrong.

You are right - the conversion makes much more sense in 99% of scenarios. I edited it to reflect that. The avoiding penalties came out of a scenario in which the person wasn't converting right away (within the sixty day window), but obviously that is a rather atypical situation.

Your advice is flawed because you are assuming 7% return over 35 years. That isn't going to happen. The average mutual fund averaged under 5% per year return over the last 20 years.

The students would be better off cashing out their 401k/Tradional IRA and using that for law school instead of accruing debt at 6-7%.

daryldixon wrote:Your advice is flawed because you are assuming 7% return over 35 years. That isn't going to happen. The average mutual fund averaged under 5% per year return over the last 20 years.

The students would be better off cashing out their 401k/Tradional IRA and using that for law school instead of accruing debt at 6-7%.

I don't agree with the above. Though of course the stock market could pull a "Japan" and crash/never recover, or a great economic boom could be right around the corner, I don't think 7% is an unreasonable assumption for a rate of return (though the actual returns could vary greatly - hence risk tolerance). The rate of return of the S&P over the last 20 years is over 8%, and over 11.5% over the last 35 years (not adjusting for inflation as the savings by avoiding accruing interest also don't).

Also, this doesn't account for wanting to have a cash reserve in case of an unexpected emergency or unemployment.

Even assuming a lower rate of return as you describe, some students may be better off financially by converting instead of spending it on law school because:
(1) They have a decent chance or better of having some loans forgiven or paid off through LRAP or another program
(2) They have a decent chance or better of having some loans forgiven (and possibly dealing with the tax bomb) because of IBR

And of course there are things like someone's risk tolerance in general, the expected debt v. the money in the IRA, and so on.