Gifting your children or grandchildren with contributions to an individual retirement account (IRA) can give them the advantage of a longer period of tax-free savings. It is definitely a gift that keeps on giving.
An IRA is a tax-deferred retirement savings account. It is similar to the employer-sponsored 401(k) plan because it also allows funds to grow tax free until withdrawn; however, it does not require an employer to open the account. Anyone with earned income can open an IRA account, with certain limitations. If you want to contribute to another individual’s IRA, it is important to understand the requirements and limitations for doing so.
Key Takeaways
- If you gift contributions to another individual’s IRA, the recipient will still be subject to the same earned income requirement as if they made their own contributions.
- The annual IRA contribution limit for 2022 is $6,000.
- Excess IRA contributions are taxed at 6% per year until the excess and all income earned on it is removed from the account.
- Gifts to a minor should be put in a custodial account, which is controlled by a guardian.
Requirements and Limitations for Gifted IRA Contributions
Even if you are giving money into someone’s IRA, the recipient must still meet the requirements to be able to contribute to their own IRA. Traditional IRA requirements include:
- Total contributions to an individual’s traditional IRAs and Roth IRAs cannot exceed $6,000 in a year (there is a $1,000 catch-up contribution allowed for those over the age of 50, for a total $7,000 in a year).
- Total contributions cannot exceed the individual’s taxable compensation for the year.
- Deduction is limited if the individual or their spouse is covered by a retirement plan at work and income exceeds certain levels.
If you contribute more than the limit, the excess contribution will be taxed at 6% unless it, and all income earned on the excess contribution, is withdrawn by the due date of the individual income tax return. The excess is taxed each year until the amount is withdrawn. This means you need to ask detailed questions before you make a gift to someone’s IRA.
Special Contribution Limit Rule for Spouses
An individual who is married and files a joint tax return can use their spouse’s taxable compensation to determine their contribution limits. For example, let’s assume you are a stay-at-home parent and your spouse makes $80,000 per year. Because your spouse’s taxable income exceeds your spouse’s $6,000 contribution limit for their IRA, you (or someone else) will also be able to contribute up to $6,000 to your own IRA.
IRA Contributions as Gifts to Minors
There are many benefits to opening an IRA for your child or grandchild. If you are gifting retirement funds to a minor, you will need to open a custodial IRA account, which the adult will maintain control of until the child turns 18 or 21, depending on the state. The custodian of the account is typically a parent, but it can be a grandparent. You will need your child or grandchild’s name, Social Security number, and address to open a custodial account for them.
You can contribute funds directly into your child or grandchild’s IRA. However, it must not exceed the $6,000 limit per year or the child’s earned income, whichever is lower. The funds deposited in the IRA do not need to be the child’s own funds. They can come directly from you. However, any funds deposited in an IRA are not able to be withdrawn by the custodian again. The custodian is only able to direct investment decisions until the child reaches the age of majority.
The downside to gifting contributions to a minor in a custodial IRA is that the child will have full control of the account at the age of majority. IRA withdrawals made prior to age 59½ are subject to an early withdrawal penalty of 10%. It is important to have open and honest conversations about finances and savings if you are going to go this route.
The Free Application for Federal Student Aid (FAFSA) will not count assets in a retirement account in the total assets for a college-bound child when determining eligibility for student aid. However, untaxed contributions and income from the account must be included on the FAFSA in the year of the transaction.
Contribution Limit Examples
If you make a gift to your teenager’s IRA, you will need to consider what their earned income is for the year. If they earned $3,500 at an afterschool job, you will be limited to a $3,500 gift to their IRA. For parents with sufficient funds, it could be a great lesson in savings to match your teenager’s earned income with a dollar-for-dollar contribution into an IRA.
Note that if your child earned, say, $6,500 during the year, you will only be able to contribute up to the $6,000 annual limit.
Will My Contribution to My Child’s IRA Cause a Gift Tax Issue?
The annual exclusion for gifts in 2021 is $15,000 per recipient, increasing to $16,000 in 2022. Because this amount is higher than any IRA contribution you can make based on IRA contribution limits, you will not need to worry about incurring a gift tax based solely on your IRA contribution gift. However, the gift will count toward your annual exclusion for gifts to your child for the year.
Even if you exceed the annual gift exclusion, you are not likely to incur any taxes as a result. You would simply be required to report the excess over the annual gift exclusion amount to the IRS on your tax return. The excess then counts against your lifetime gift exclusion, which is $11,700,000 for 2021 and $12,060,000 for 2022.
Can I Contribute to My Child’s IRA if They Do Not Have Any Earned Income?
No. The IRA owner must have taxable compensation, also known as “earned income.” Taxable compensation comes from salary or wages paid by an employer, commissions, tips, or self-employment income. If your child does not have earned income, you cannot contribute to an IRA on their behalf.
Other forms of income are considered to be unearned income, which cannot be applied to IRA contribution limits. Unearned income includes income from sources such as interest, dividends, pensions, unemployment, and Social Security.
The exception to this rule is if your child is married, files a joint return with their spouse, and said spouse has sufficient earned income. You could contribute to an IRA in your child’s name in this circumstance.
Are There Other Ways to Gift an IRA to My Children?
Should I Contribute to a Traditional IRA or a Roth IRA for My Child?
It depends on your family’s current and future tax situation. A Roth IRA is funded with after-tax dollars rather than pretax dollars, as with a traditional IRA. This means that when your child withdraws funds from a Roth IRA during retirement, it is tax free. Whether it makes more sense for your child to withdraw funds tax free or pay taxes in retirement should be a consideration when you choose the type of IRA account. The Roth IRA is subject to the same earned income requirement and $6,000 limit as a traditional IRA.