Lending money to your children can be a valuable part of retirement planning because it can help a family and avoid gift and estate taxes, according to Jonathan Bergman, vice president of Palisades Hudson Financial Group, a financial planning and investment firm in Scarsdale, N.Y.
Let's say your son and daughter-in-law are contemplating buying a home. They qualify for what would be a jumbo loan in most parts of the country. But, if they had another $100,000, they could get a qualifying loan and that would drop the interest rate on a 30-year fixed mortgage a half a percent into the low 4 percent range.
The Bank of Mom and Dad can come to the rescue with a $100,000 loan at, perhaps, 4 percent -- a return that is far better than the paltry 1.7 percent that is available on a long-term CD, a popular retirement investment. And the kids pay less for their new home.
Plus, "the bank's profit stays in the family," Bergman says.
Parents also might consider lending the whole mortgage. Even families of relatively modest means could benefit from these familial loans with mom and dad enjoying a reasonable interest rate on their retirement money and junior avoiding significant closing costs and mortgage insurance.
Bergman points out that large loans have advantages over gifts. Each year, any individual can give only a limited amount to another individual, including a child, without having to file a gift tax return. For 2010, the cap is $13,000. Gifts beyond that amount also count toward a lifetime limit on tax-free gifts, set at $1 million.
The IRS requires a minimum rate to be charged for a loan not to be considered as a gift. The Applicable Federal Rate for September is 0.46 percent for terms less than three years; 1.94 percent for a three- to nine-year loan; and 3.66 percent for more than nine years.
Family loans also offer a retirement planning strategy to reduce estate taxes, Bergman says. A parent makes a loan to a child, which the child can then invest, seeking to earn more than the interest he pays. If the parents had invested the money directly, those gains would belong to the parents and could be subject the estate and/or gift tax when passed on to the child.
Bergman says his firm has handled five or six of these sorts of loans this year. The largest he has ever done was a $13 million loan to a trust for very young beneficiaries. The trust is paying this particular Bank of Mom and Dad 1.65 percent for nine years on the $13 million loan. It has invested the money, mostly in stocks.
The deal was completed in February 2009, at what turned out to be the bottom of the market. Since then, Bergman says the portfolio has gained 63 percent, transferring $8 million to the next generation of the family without any obligation to pay estate taxes.
"Everyone wins," Bergman says.