The sooner you can get money into an individual retirement account, the longer you can take advantage of the tax-sheltered savings. To help with this, parents may want to contribute to an IRA for their children. However, because of gift taxes and IRA contribution requirements, it's not always possible.
Parent Must Give Money
Parents can't put money directly into their child's IRA like they can with a child's savings account. Money that parents give to their child is potentially subject to gift taxes. As of 2012, you can give up to $13,000 to a person, including your child, tax-free. For example, if you give your child $5,000 to contribute to an IRA, you would have no gift-tax liability because your gift doesn't exceed the annual gift-tax exclusion. However, if you had already given your child gifts of $13,000, your gift of money for an IRA contribution would trigger gift taxes. Gift taxes only apply to the person giving the money. If a child receives the money, she's not liable for this tax.
Child Must Qualify
Once you've given the money to your child, she can only put it in his IRA if she qualifies to make an IRA contribution. The most likely barrier to making a contribution to a traditional or Roth IRA is that the child must have earned income equal to or greater than the contribution. Earned income includes salary, wages and self-employment income. If your child doesn't have earned income, she can't put money in an IRA. For example, if she just has $1,000 of baby-sitting self-employment income, she could only contribute that amount to an IRA.
Money given by a parent to a child to contribute to an IRA counts toward the annual contribution limit. For example, assume the contribution limit for your child is $5,000. If your child has already contributed $4,000 to her IRA, she can only add another $1,000 from her parents' gift. If your contributions plus your child's money exceed the annual contribution limits, the IRS imposes a 6 percent penalty each year the excess isn't corrected.
Any deduction resulting from an IRA contribution is taken by the person whose IRA receives the money. For example, if you give money to your child and your child contributes the money to a traditional IRA, the deduction goes on your child's tax return. However, if the person making the contributions is covered by a retirement plan at work, traditional IRA contributions aren't deductible if this person's modified adjusted gross income exceeds the annual limit. As of 2012, this limit is $112,000 for someone who is married and filing taxes jointly.
Mark Kennan is a writer based in the Kansas City area, specializing in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."