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. However, the recipient needs to have earned income, and other rules apply.
An IRA is a tax-deferred retirement savings account. It is similar to the employer-sponsored 401(k) plan because it allows funds to grow tax-free until withdrawn; however, it does not require an employer to open the account.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, with certain limitations.
If you want to contribute to another individual’s IRA, it is important to understand the requirements and limitations of doing so.
Key Takeaways
- If you give contributions to another person’s individual retirement account (IRA), the recipient still will be subject to the same earned income requirement as if they made their own contributions.
- The annual IRA contribution limit is $6,500 in 2023 (plus an additional $1,000 in catch-ups if you’re age 50 or older). In 2024, the limit increases to $7,000, with the same $1,000 catch-up for those 50 and older.
- Excess IRA contributions are taxed at 6% per year until the excess and all income earned on it are 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 to someone’s IRA, the recipient still must meet the requirements to be able to contribute to their own IRA. Traditional IRA requirements include:
- Total contributions to an individual’s traditional and Roth IRAs cannot exceed $6,500 in a year for 2023. Plus, there is a $1,000 catch-up contribution allowed for those ages 50 and older, for a total of $7,500. For 2024, the limit increases to $7,000 and $8,000, respectively—an increase of $500 over the 2023 contribution limit.
- Total contributions cannot exceed the individual’s taxable compensation for the year.
- The tax deduction is limited if the individual or their spouse is covered by a retirement plan at work and income exceeds certain levels.
If an individual contributes more than the limit to their IRA, the excess contribution will be taxed at 6% unless it—and all income earned on the excess contribution—are withdrawn by the due date of the individual income tax return. The excess is taxed each year until the amount is withdrawn. To avoid these problems, you need to ask the potential recipient detailed questions before you make a gift to their IRA.
Special Contribution Limit Rule for Spouses
An individual who is married and files a joint tax return can use their spouse’s earned income to determine their contribution limits.
For example, let’s assume that a couple includes a stay-at-home parent and a spouse who makes $80,000 per year. This amount permits each spouse to make a $6,500 contribution to an IRA in 2023, for a total of $13,000—well under the $80,000 that the spouse earns. In fact, if both spouses are age 50 or older, they can each contribute $7,500.
Knowing these rules will show you the maximum you could give each spouse for their IRA—as long as your gift and any other contributions are no larger than the annual limit.
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, which you, as an adult, will maintain control of until the child turns 18, 19, or 21 years old, depending on the state. The custodian of the account is typically a parent, but it can be a grandparent. You will need your child’s or grandchild’s name, Social Security number, and address to open a custodial account for them.
You can contribute funds directly to your child’s or grandchild’s IRA. However, it must not exceed the annual contribution 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, as long as that child has earned income.
Note that any funds deposited in an IRA are not able to be withdrawn by the custodian again. What’s more, 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) only considers income reported on federal tax returns. That means you no longer must report certain untaxed income sources, including contributions to tax-deferred retirement accounts, such as 401(k)s and 403(b)s.This change may benefit parents who increase or maximize their retirement-savings paycheck deductions.
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 after-school 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 earns, say, $7,000 during the 2023 tax year, you would be able to contribute only up to the $6,500 annual limit.
Will My Contribution to My Child’s Individual Retirement Account (IRA) Cause a Gift Tax Issue?
The annual exclusion for gifts in 2024 is $18,000 per recipient, up from $17,000 in 2023. Because this amount is higher than any IRA contribution that 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 simply would be required to report the excess over the annual gift exclusion amount to the Internal Revenue Service (IRS) on your tax return. The excess then counts against your lifetime gift exclusion, which is $12.92 million for 2023, increasing to 13.61 million for 2024.
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, then 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 their spouse has sufficient earned income. You could contribute to an IRA in your child’s name in this circ*mstance.
Are There Other Ways to Give an IRA to My Children?
If you contribute to your own IRA during your lifetime, you can gift the IRA to your children as an inheritance after your death. You can do so by designating your children as the beneficiaries of your IRA.
Should I Contribute to a Traditional IRA or a Roth IRA for My Child?
It depends on your family’s current and future tax situations. A Roth IRA is funded with after-tax dollars rather than the pretax dollars that a traditional IRA is funded with. 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. (Note that not owing taxes on, say, 40-plus years of earnings on a Roth contribution could save that child a lot when they retire.) The 2023 Roth IRA is subject to the same earned income requirement and $6,500 ($7,500 if you’re age 50 or older) limit as a traditional IRA. The contribution limits increase to $7,000 for 2024 ($8,000 for those over age 50).
The Bottom Line
Learn the requirements of giving to another person’s IRA before you contribute to an IRA for a child or grandchild. You will need to open a custodial account if the recipient is not yet a legal adult. Remember that you can contribute no more than the recipient’s earned income for that tax year.
