A Gift to Start a Roth IRA

A boring gift can be good

By Kaye A. Thomas
Posted December 25, 2007

The important thing isn't the money, or even the investment.

Our three daughters are old enough to be earning some money but not old enough to be paying much income tax. This makes them ideal candidates for the Roth IRA.

If they put money in a traditional IRA, they get a tax deduction but it doesn't do them any good because they aren't paying income tax anyway. But there's a good chance they'll have to pay tax when they take the money out, and they may end up being hit with a 10% early distribution penalty as well.
If they put money in a Roth IRA, they don't get a deduction but that doesn't matter because the deduction is worthless to someone who isn't earning enough to pay income tax. They can withdraw the contribution money at any time without paying tax or penalty. And if they're smart enough to keep their hands off the investment earnings, those can ride through until retirement and become entirely tax free.

Like many young adults, our daughters don't put a high priority on saving for anything, much less for retirement. I decided to get them started by helping them set up Roth IRAs and making gifts in the form of contributions.

Can you do that?

To make IRA contributions our daughters need to have qualifying income, which generally means earned income. A gift doesn't count as income at all, and certainly isn't qualifying income. But it's okay to fund an IRA with gift money if the IRA owner earned money in the same year, even assuming that money is long gone at the time you make the gift (or conversely, won't be earned until after the gift). The IRA owner needs to have earnings in the same year, but the IRA contribution doesn't have to come from the earnings.

It's not the money

I'm certainly not the first person to do this. Some people see this as a way to transfer a good chunk of wealth to their children and put them into investments that can be expected to show strong growth. My gifts aren't that large, and my focus is a little different. It would be nice to see these accounts grow into a nice nest egg, but what I'm really trying to do is impart some knowledge. To that end, I've composed letters to go along with the gifts. While our daughters may not see it that way, the letters are potentially more valuable than the money that goes into their accounts, if they actually learn anything from them. Maybe our daughters will drain these accounts for something frivolous before seeing any genuine benefit from them. That would be regrettable, but they'll still have learned how to set up an IRA and picked up a little about investing. In the long run that's more important than what happens to a few hundred dollars, or even a few thousand.

The letters

Anyone thinking of doing something like this can certainly make up their own letters, but I offer mine here (edited a bit to make them somewhat generic) for what they're worth. Feel free to copy any of the ideas or use the bad jokes. Here's the design philosophy:

Keep it light. This is a gift occasion, so let's try not to be any more pedantic than necessary.
Keep it short. Even if you force them to read it, they'll tune out after a while. The investing chapter in Go Roth! is over 30 pages, but I keep these letters to about a page and a half.
Hit the important points. There are really just a few key principles to successful investing. I mention two or three of them in each letter, and plan on repeating them in subsequent letters to drive home what I really want them to learn, within the constraints of the first two design requirements above.

I didn't write these with the idea they would end up on my website, but my wife suggested posting them and I try to take her suggestions whenever possible.