How To Make an IRA Contribution as a Gift

Established savers can help to give others a leg up on preparing for retirement through gifted contributions to an individual retirement account (IRA). However, there are certain requirements and limitations to keep in mind if you’re thinking of making an IRA contribution as a gift.

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

Further, a key advantage these funds have over 401(k)s is that almost anyone with earned income can open and self-manage an IRA, making them an ideal choice for givers looking to help those in need of a retirement boost—say, a child or grandchild.

Requirements and Limitations for Gifted IRA Contributions

An IRA holder must be eligible to contribute to their own fund to be able to receive a gift contribution. It’s therefore essential that you ensure your potential recipient meets the following traditional IRA requirements, as well as any others that may apply in their individual case:

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. Total traditional and Roth IRA contributions must also not exceed the IRS’s annual overall contribution limit, or else the account holder will face an overcontribution penalty.
4. Tax deductions may be impacted by the individual’s (and/or their spouse’s) employer-sponsored retirement plans as well as their household income.

In many cases—including those in which an older saver wishes to make IRA contributions on behalf of a much younger relative—the key limitation will be the recipient’s taxable compensation. If that recipient does not have taxable income, a gift contribution will not be possible for that year. 

If they do have qualifying income, but it is very modest, the maximum contribution will be limited as well. For example, if the recipient has only $1,000 in taxable compensation for the year, your gift may not exceed that amount. Of course, with the power of compounding, that contribution can still lead to much greater benefits many years down the line.  

It’s important for those gifting IRA contributions to keep in mind the penalties account holders face for exceeding the annual limit, particularly given that 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. Excess for one year will continue to be taxed in subsequent years until this correction is made.

Special Contribution Limit Rule for Spouses

Those IRA holders who are married and filing a joint tax return may determine their contribution limits based on their spouse’s earned income (that is, an individual may be eligible to contribute to an IRA even if they do not have taxable compensation for a given year, so long as their spouse does).

As a hypothetical, a married couple including one person earning $60,000 per year and another not working will be eligible to make contributions to an IRA. Each spouse can contribute up to the individual annual limit, so long as it does not exceed the $60,000 income of the working spouse. If either spouse is age 50 or older, they can also make a catch-up contribution.

IRA Contributions as Gifts to Minors

Opening an IRA for your minor child or grandchild provides significant benefits, so long as they have taxable income, but there are also additional considerations to keep in mind. First, you will need to open a custodial IRA for you to maintain control of until the child reaches the age of majority (typically 18 years, but up to 21 years depending upon the state). In order to open a custodial account, you’ll 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 the child’s behalf. However, these gifts must not exceed the annual limit (either the overall limit or the child’s earned income, whichever is lower for a given year). The funds may come from you as the custodian and do not need to be deposited by the child.

The custodian maintains authority to direct investment decisions until the child reaches the age of majority. It’s essential to have conversations with the recipient prior to this time to ensure they understand how to oversee the account, as well as the stiff early withdrawal penalties tied to IRAs.

Contribution Limit Examples

A wonderful thing about gifting contributions to a custodial IRA is that funds may come from the custodian and do not need to be deposited directly by the child. So if, for example, a minor teenager with an after-school job earns $2,000 in taxable compensation for a year, a custodian can make a matched, dollar-for-dollar contribution of $2,000 into an IRA on that teenager’s behalf.

The Bottom Line

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