Parents spend more than $500 billion annually assisting young adults with student loans, housing, groceries, car payments, cell phone bills and other expenses, according to a recent Merrill study. For many families, that largesse is in the form of a gift, but some parents may call it a loan—and treat the transaction as a lesson in money management.
When gifting or lending is done right, it can help young adults get a first home, a car or a college education that they otherwise wouldn’t be able to afford. Or the money may be just what a relative needs to get back on his feet. But done wrong, handouts can undermine a young adult’s independence and generate hard feelings among other family members who don’t get gifts or loans. If it’s a loan that’s never repaid—whether you wrote the check or co-signed for a loan from a lender—it may create a lasting rift with the borrower and potentially leave black marks on your credit history.
Giving or lending money can also affect your lifestyle and retirement plans. Jennifer Myers, a certified financial planner in McLean, Va., says she usually runs projections for clients on how a potential gift—or a loan that might never be repaid—might affect their ability to retire when they want. “You have to make sure you can afford to help that family member or friend and still be financially secure yourself,” she says. But Myers acknowledges that it’s hard to say no to someone you love. “A lot of times, people follow their heart and put their finances second,” she says.
Lending or giving money to family members can be rewarding, but you need to be aware of the risks. Here are some smart ways to give or lend money without sacrificing family harmony.
Skin in the game
Many parents worry that giving money to an offspring will spoil the child’s ambition or drive, says Ryan Thomas, a CFP in Indianapolis. “It’s human nature that you don’t appreciate it as much if you didn’t work for it,” he says.
To avoid this, parents can require a commitment from the child. For example, parents who have saved enough for college can encourage students to apply for scholarships—which often require maintaining a high GPA—by promising to match the amount of scholarships awarded after graduation, Thomas says. Or parents can help young adults build a nest egg by reimbursing the money they put in a Roth IRA or 401(k)—once they’ve provided proof of their contributions.
Making a loan
Never lend more money than you can afford to lose. “You hope you are going to get the money back, but you always have to go into a family loan with the notion that you might not see the money again,” says Myers.
Make loans a business transaction. Memories fade, and to avoid disputes over whether the money was a gift or a loan, write the terms—including the amount, repayment schedule and any interest to be charged—in a promissory note and have both sides sign it.
Loans that aren’t documented are often not repaid. That’s what Alex Tran, a digital marketing strategist in Seattle, found. She lent $500 to a relative 11 years ago but was never repaid despite her efforts to collect. After that, whenever she lent money, she drew up a contract with the loan terms. She’s made about 10 loans and hasn’t had one go bad since creating the contracts. “It looks professional and also keeps them accountable for returning my money,” says Tran.
Another reason to put loans in writing: If you’re not repaid, you could deduct the loss on your tax return as a bad debt, says Blake Christian, a CPA with accounting firm HCVT in Park City, Utah. “The IRS is absolutely going to scrutinize any bad debt,” he says. The agency also requires you to document your efforts to collect the money. The IRS will assume that a family loan is a gift unless you can prove otherwise, says Mark Luscombe, principal analyst for Wolters Kluwer Tax & Accounting. To avoid issues with the IRS, document the loan and charge interest on large loans, he says. (You’re not required to charge interest if the loan is for less than $10,000 and won’t be used to purchase an investment—or up to $100,000 if the borrower’s investment income for the year is less than $1,000.) The IRS offers guidance on interest rates. Each month, it publishes a minimum amount of interest—called the Applicable Federal Rates—that must be assessed on new private loans, depending on the duration of the loan. In June, the annual interest rate was 2.33% on loans for three years or less, 2.38% on loans for up to nine years and 2.76% for longer loans. You must report the interest income on your tax return. To get the most recent AFRs, go to www.irs.gov and search for “Applicable Federal Rates.”
If you’d prefer to make a gift, you may also be able to use the tax code to your advantage. Although cash is nice, you might save on taxes by giving appreciated securities instead, if your income is higher than the recipient’s. (Your cost basis and holding period on appreciated securities will transfer to the recipient.) The federal long-term capital gains tax rate for investments held more than a year can be as high as 23.8%, depending on your income. But if the recipient’s income is low enough, the gains on the sale of securities could be taxed at a rate of 15% or even 0%.
Help buying a house
If they were a business, friends and family would be the seventh-largest mortgage lender in the U.S., according to a recent study sponsored by Legal & General, a financial services company.
Sylvia Wu, 30, of Kailua, Oahu, bought a $210,000 condo as an investment property while in college in 2009 with the help of her parents, who saw the weakened housing market at the time as a prime opportunity. Wu says she had $35,000 for the down payment, but she couldn’t qualify for a mortgage because she worked only part-time. Her parents borrowed against their home and lent $175,000 to Wu so she could buy the condo outright. Her mother drew up a promissory note with the terms. Wu, now an education specialist at the University of Hawaii at Manoa, used rental income from the condo and her paycheck to repay the debt with interest.
Her parents provided a similar loan to Wu’s sister. “My sister and I are totally fine with making this arrangement very formalized and paying interest to my mom,” says Wu.
The easiest way to help a family member with a home purchase is to provide the down payment as a gift. You’ll need to supply recent bank statements and a “gift letter”—signed by you and the home buyer—that verifies the money isn’t a loan that must be repaid, says Rick Bechtel, head of residential lending at TD Bank.
If you want to lend money to help finance part of the home purchase, the process is more complicated. A lender will take into account the monthly debt payment due you when deciding whether the home buyer can qualify for a mortgage, says Bechtel.
Whether your loan will cover just part of the purchase or the full amount, documentation will be key. Besides creating the promissory note, many parents also opt to file a mortgage or deed of trust with their local government—such as the registrar of deeds or county clerk’s office—creating a lien on the property, says Timothy Burke, founder and CEO of National Family Mortgage, which helps administer loans between immediate family members. This step is necessary if the homeowner wants to deduct the mortgage interest she pays you, Burke says. The lien also protects you in case of default. You could foreclose, although your loan would be second in line for repayment if the homeowner has a first mortgage with a lender—and it would be difficult to make such a decision with a child or other relative.
A lawyer—and in some states a title-company attorney—can help you draw up the promissory note and file the paperwork. National Family Mortgage can also help you create and service the loan. The company can set up the promissory note, help with filing the necessary paperwork with local authorities, manage the payments, send out late-payment notices if needed, and generate year-end IRS tax forms (a 1098 mortgage interest statement to the borrower and a 1099 income statement to you). The cost, depending on the size of the loan, is a one-time fee ranging from $725 to $2,100, plus a minimum of $15 a month for servicing the loan.
The risks of co-signing
Many college students who have maxed out on federal student loans turn to private loans to fill in the gaps, but they usually need a co-signer to qualify. This can have repercussions for the co-signer. If the primary borrower doesn’t repay, the co-signer is responsible for the debt. Plus, a co-signer’s credit history can be damaged if the borrower misses payments or makes them late, says Jeremy Heckman, a CFP in Edina, Minn. You might not be aware of the problem until you apply for credit, says Heckman, who discourages clients from co-signing.
But some people put their credit on the line with their eyes wide open. Phil La Duke, 56, of Allen Park, Mich., agreed to co-sign private student loans for his daughter Jennifer. “I made a commitment to her early on: ‘You worry about getting into the best school you possibly can, and we’ll figure out how to finance it,’ ” he says, adding that he expected to help her repay the loans.
She was accepted at Loyola University Chicago, where she graduated in 2009 with degrees in journalism and English—and $145,000 in private loans. Jennifer found a job as an editor at a trade publication and was making loan payments until she was laid off in late 2010. Her dad continued the payments, and now about half of the debt has been repaid.
La Duke, a safety consultant and author of workplace-safety books, says he would have a more comfortable retirement if the money had gone into his savings instead, but he has no regrets about investing in his daughter’s future. “I can’t think of a better way to spend my money,” he says.
Jennifer, 32, has been working in early childhood education for the past nine years and plans to go back to school this fall to get a master’s degree in the field. This time, she says, she anticipates that a scholarship and an employer-assistance program will cover nearly all of the tuition. “I feel like I learned my lesson with my undergraduate degree,” she says.
Know the tax limits
You can give up to $15,000 a year to an individual without having to file a gift tax return (married couples can give a total of $30,000 per person). Any sum over the limit chips away at the amount you’ll be able to exempt from federal estate and gift tax. (This is likely not an issue for many, given that an individual can now exempt up to $11.4 million in lifetime gifts and bequests from federal gift and estate tax.)
There are ways to give higher amounts without having to file a gift tax return. You can pay a student’s tuition directly to the school or help with a relative’s medical bills and health insurance premiums by making payments directly to the hospital, doctor or insurer, says Christian.
Besides estate and other tax issues, parents often grapple with guilt and worries about family harmony. When parents give or lend money to one child, siblings may feel resentful. Being up front with family members about why you’re providing assistance can help prevent ill feelings, says Heckman. For instance, parents can explain that they are giving one child the down payment for a house and will do the same for the others when they’re ready to buy, he says.
Some parents and grandparents try to balance things out by making equal gifts to other family members at the same time. Others make things fair through estate documents. If one child is given $50,000 to, say, buy a home or pay for grad school, that child’s inheritance will be reduced by that amount and adjusted for inflation (see Estate Planning: A Family Affair).
Fund college the right way
Many grandparents want to help their grandchildren pay for college by funding some of their tuition. But this generosity could backfire if the student is eligible for financial aid.
If the student won’t qualify for need-based aid, you can pay the child’s tuition directly to the school. Or you can contribute to a state-sponsored 529 college savings plan when the child is young and the money has time to grow. Contributions are after-tax, but the principal and earnings can be withdrawn tax-free for qualified education expenses. More than 30 states offer a tax deduction to residents contributing to the home-state plan.
If the student is likely to qualify for need-based aid, grandparents should consider different strategies. Withdrawals from a grandparent’s 529 account are considered untaxed income to the student, which can significantly reduce aid in subsequent years. And if a grandparent pays tuition directly to the school, the money will be viewed either as untaxed student income or as a funding resource that will reduce aid eligibility, says Mark Kantrowitz, publisher of the website SavingforCollege.com. An easy way to avoid this problem is for grandparents to contribute to the parent’s 529 account because those withdrawals will have less impact on aid, says Kantrowitz. Or they can wait until the student graduates and help repay any education loans.
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