Can You Fund an IRA with Alimony or Child Support?

Dear Carrie,

I was divorced last year and receive both alimony and child support from my ex. Can I use this money to fund an IRA?

—A Reader

Dear Reader,

While I'm happy to see you're interested in funding an IRA, unfortunately, under current tax law you can't use either alimony or child support to do it. IRA contributions can only be made from earned (taxable) income. Child support has never been taxable. And while alimony used to be considered taxable income, the Tax Cuts and Jobs Act of 2017 changed that. If the divorce agreement was signed after December 31, 2018, alimony is neither tax deductible for the payer nor taxable for the recipient.

So the good news is you don't need to pay income taxes on your alimony. On the flip side, you can't use it to contribute to a tax-advantaged IRA. But that doesn't mean you can't invest this money wisely.

Before you invest, think about three things: what you're investing for, how much risk you can afford to take, and the time you have to keep your money invested. Then take a careful look at your current financial situation. Do you have an emergency fund? Are you getting the full match in your 401k? Are there gaps in your insurance needs? Do you have credit card debt? These factors will help you determine how much and where you should invest. 

Child support is intended to be used specifically for the benefit of the child. So even though you can't use child support and alimony to fund an IRA, there are several other smart ways to invest it. Some are taxable and some offer tax advantages similar to an IRA. Here are a few options to consider:

• Brokerage account—A brokerage account doesn't provide tax deferral, but there are no contribution or withdrawal limits. You can use a regular brokerage account or set up a custodial brokerage account under the Uniform Gifts to Minors Act (UGMA) or the Uniform Transfers to Minors Act (UTMA) to invest for a variety of goals. Investing in a broad-based mutual fund, exchange-traded fund (ETF) or fractional shares is one way to get started.
• Health Savings Account (HSA)—An HSA is available if you have a qualifying high-deductible health plan (with minimum deductibles currently at $1,400 for individuals and $2,800 for families). You may think of it only as a way to save for medical expenses, but there's more to it. Contributions are tax-deductible federally and in most states, and earnings grow tax-sheltered. Plus, there's no tax on withdrawals if used for qualified medical expenses. On top of that, the money rolls over year after year and you can typically invest it similar to an IRA. It can be a great way to cover your family's health care costs as well as save and invest for the future. Contribution limits for 2022 are $3,650 for an individual, $7,300 for a family.
• 529 College Savings Plan—A 529 is an excellent way to save for your kids' college and enjoy some tax perks too. Some states offer tax deductions or credits for contributions, earnings grow tax sheltered—and you don't pay federal income tax (or state income tax in most states) on withdrawals as long as the money is used for qualified education expenses. This includes a variety of post-secondary options as well as up to $10,000 annually in elementary or high school tuition.

Since we're talking about tax advantages, here's a reminder about the Child Tax Credit as well as the Child and Dependent Care credit. Each tax credit has been expanded for this year by the American Rescue Plan—and each can be significant in reducing your tax liability and possibly increasing the amount of money you can save and invest.

You don't say if you have earned income in addition to alimony and child support, but if you do, try to carve out something for an annual IRA contribution. It can be a challenge, but even a small amount saved consistently can make a big difference in your future. Your best bet? Make it automatic! For an extra boost, see if you qualify for the Saver's Credit, which is a special tax break for low- to moderate-income taxpayers saving for retirement.

As you can see, you have a number of options for putting your money to work for you and your child. Check in with an accountant or financial advisor to make sure you're taking full advantage of all the possibilities and to help refine your strategy.

Have a personal finance question? Email us at askcarrie@schwab.com. Carrie cannot respond to questions directly, but your topic may be considered for a future article. For Schwab account questions and general inquiries, contact Schwab.