How to Make an IRA Contribution as a Gift

Institutional savers can help give others a chance to prepare for retirement through gifted contributions to an individual retirement account (IRA). However, there are certain requirements and restrictions to keep in mind if you are considering making an IRA contribution as a gift.

IRAs are tax-deferred retirement savings accounts that operate similarly to employer-sponsored 401(k) plans in that investors can set aside money intended for growth on a tax-free basis until retirement or early withdrawal. The best IRA accounts provide investors with a wide range of investment options, educational resources, low fees, and other benefits.

Furthermore, the main advantage these funds have over a 401(k) is that almost anyone with earned income can open and self-manage an IRA, making them an ideal choice for donors looking to help those who need a retirement boost — for example, a child or grandchild.

Requirements and restrictions on gifted IRA contributions

An IRA holder must be eligible to contribute to his or her own fund in order to receive a gift contribution. It is therefore essential to ensure that the potential recipient meets the following Traditional IRA requirements, in addition to any others that may apply to his or her individual situation:

1. The account holder must have taxable compensation for the year.
2. Total contributions (by the account holder or as a gift to the account holder) may not exceed that person’s taxable compensation for the year.
3. The total of traditional and Roth IRA contributions must also not exceed the IRS’s annual aggregate contribution limit, or the account holder will face an excess contribution penalty.
4. Tax deductions may be affected by employer-sponsored retirement plans (and/or their spouses) as well as family income.

In many cases — including those where an older saver wants to make IRA contributions on behalf of a younger relative — the main limitation will be the recipient’s taxable compensation. If that recipient does not have taxable income, it will not be possible to contribute a gift that year.

If they are He does They have qualifying, but very modest, income, and the maximum contribution will also be limited. For example, if the recipient only has $1,000 in taxable compensation for the year, your gift may not exceed that amount. Of course, with the power of compounding, this contribution can still yield much greater benefits for many years.

It is important for those who make IRA contributions to keep in mind the penalties account holders face for exceeding the annual limit, especially since gift contributions are included in these totals. Any excess contribution beyond the annual limit — as well as any income earned on that portion of the annual contribution — will be taxed at a 6% penalty rate unless that contribution and income are withdrawn by the due date of the account holder’s income tax return. The one-year surplus will continue to be taxed in subsequent years until this correction is made.

Special rule to limit contributions for married couples

IRA holders who are married and file a joint tax return may set their contribution limits based on the earned income of their spouse (i.e., an individual may be eligible to contribute to an IRA even if they do not have taxable compensation for a given year, as long as their spouse does).

Hypothetically, a married couple, including one person earning $60,000 a year and one who is not working, would be eligible to make contributions to an IRA. Each spouse can contribute up to the individual annual limit, as long as it does not exceed the working spouse’s income of $60,000. If one spouse is aged 50 or over, they can also make a catch-up contribution.

IRA contributions as gifts to minors

Opening an IRA for your minor child or grandchild offers significant benefits, as long as they have taxable income, but there are also additional considerations to keep in mind. First, you’ll need to open a custodial IRA so you can maintain control over it until the child reaches the age of majority (usually 18, but up to 21 depending on the state). In order to open a custodial account, you will need personal information about the child, including name, Social Security number, and address.

Custodial IRAs allow the adult custodian to make a direct contribution on behalf of the child. However, these gifts must not exceed the annual limit (either the total limit or the child’s earned income, whichever is lower for a given year). The funds may come from you as the guardian and do not need to be deposited by the child.

The guardian retains the authority to direct investment decisions until the child reaches the age of majority. It is essential to have conversations with the recipient before this time to ensure they understand how the account will be supervised, as well as the strict early withdrawal penalties associated with IRA accounts.

Examples of contribution limits

The great thing about gifting contributions to a custodial IRA is that the funds may come from the custodian and do not need to be deposited directly by the child. So, for example, if a minor teen working an after-school job earns $2,000 in taxable compensation for a year, the trustee could make a dollar-for-dollar matching contribution of $2,000 to an IRA on that teen’s behalf.

Bottom line

Making a gift contribution to an IRA is one of the most impactful ways you can support someone’s retirement readiness. However, there are important considerations to take into account, including annual contribution limits, requirements regarding taxable compensation, and use of a custodial account for minor beneficiaries.