Much of the press around gifting children is cast in a negative light: implying that children are greedy or unmotivated, and the parents gifting money are pushovers. But what if such transfers are viewed in a different way? The children get a boost at a time when they need it the most, the parents feel good about being able to help, and family bonds are strengthened. Plus, when funds are used for investment purposes, it can actually add to the family pot.
Is Parental Help Empowering or Enabling?
It’s easy for loving parents to fall into a trap where they keep giving a needy adult child money without seeing any progress on the part of the child to get on his or her feet. Pouring more money into a stagnant situation is not helpful. But parents may feel they have no choice; if they stop paying, the child could go under (get evicted, lose insurance, default on loans, etc.). In these cases, you need to work out a plan that you both can agree to – it might involve reducing the payments little by little or setting a deadline after which no further payments will be made.
If the transfer promises to be empowering – say it’s a loan to get through school, start a business or buy a home – be positive and encouraging, but also realistic. Run the numbers to make sure you aren’t depriving yourself or hurting your own future.
Although children receiving such aid may say they’ll be in a position to help their parents later on if necessary – once their degree has gotten them a high-paying job, or once the business is successful – parents should retain their financial independence by determining how much they can afford to give without impairing their own financial security.
Before you contribute money to a child, consider the following:
Where is the money coming from?
If you’re planning a large gift or loan and the money is currently in an IRA, retirement plan or investment account, consider the financial repercussions of the withdrawal, such as early withdrawal penalties, income taxes on the distribution or capital gains taxes from the sale of assets.
Also consider the opportunity cost of paying taxes sooner than needed on those retirement plan distributions, or the loss of future investment earnings on the securities that were liquidated. Without proper planning, the loan or gift could cost more than you anticipate.
What will the impact be on other family members?
While you could gift a child without other family members – like other children – not knowing, these things have a way of coming out. When financial dealings are unequal and shrouded in secrecy, resentments build.
If you propose to help one child financially, seriously consider how to create equality among the siblings, where it’s by transferring an equal amount or revisiting the will to even things out in the end. The worst legacy a person can leave is squabbling children.
Is the transfer a gift, loan or investment?
Generational transfers can take several forms depending on the purpose and how the money is used.
- The gift could be just that, a gift. This is the most simple route, but it doesn’t involve repayment.
- The gift could be a loan, with an established interest rate and mutually agreed-upon repayment schedule.
- The gift could be structured as an investment, whereupon the happening of some event (sale of a business, sale of a house) the gift is paid back, in part or in full.
Whichever route you choose to take, there must be clarity from the outset. Which is it, a gift or a loan? If it’s a gift, say so. If it’s a loan, draw up specific repayment terms, perhaps using a tool like LoanBack. But to hand over a check and mumble something like, “pay me back when you can,” creates uncertainty and could lead to bad feelings down the road.
What are the tax implications?
As far as the IRS is concerned, the annual gift tax exclusion is $16,000, so any gift under that amount has no tax consequences and there’s no need to file a gift tax return.
If you structure the gift as a loan, you may decide to charge an interest rate that’s less than what your child would pay on a commercial loan, but more than you could get in a comparable CD or debt security. Many families structure their intra-family loans this way, and they work out well for everyone. But one possible downside is that repayments do not go onto the child’s credit report. Another downside is that the child could always default on the loan, in which case the loan turns into an unintended gift.
When setting up an intra-family loan, make sure the borrower pays an interest rate at least equal to the Applicable Federal Rate. This will avoid having the loan be deemed a gift and will get around the need to file a gift tax return if the amount exceeds the annual gift exclusion. If the loan later turns into a gift – because the child defaults or you forgive it – you can file the gift tax return at that time.*
*Note that until the entire lifetime gift and estate tax exemption is used up, which is currently at $12.06 million per person, there will be no gift taxes due. The filing of the gift tax return is simply a way to keep track of lifetime gifts so they can be applied against the exemption at death. No payment needs to be made at the time the gift tax return is filed.
The interest payments you receive on the loan are subject to ordinary income tax. They are not tax-deductible to the borrower unless the loan is structured as a mortgage, with a first or second home serving as collateral for the debt.
What about co-signing a loan?
If you prefer to not give or lend money to your kids, you might consider co-signing a loan. This is a very risky course of action, because you are partly responsible for the loan, but you have no control over the repayments. But, sometimes this is the only way a transaction can be done.
Under the best-case scenario, the child makes the payments on time and your involvement is never needed. This also helps the child build credit. Under the worst-case scenario, the child defaults and you pick up the payments. Such payments would then be considered loans or gifts to the child and be managed accordingly.
If you still need assistance on structuring a gift or transfer, consider working with a financial advisor. Our advisors can help you build a holistic financial plan and achieve your goals, which includes strategies to make financial gifts to people and philanthropic organizations that mean the most to you.
Elaine Floyd, CFP, is Director of Recruitment and Life Planning for Horsesmouth, LLC.