Helping Family in Hard Times

EDITOR'S NOTE: This article was originally published in the December 2008 issue of Kiplinger's Retirement Report. To subscribe, click here.

A stock market gone wild. A deepening recession. Rising unemployment. This is a heck of a time to be hit up for a loan -- or a gift -- from a family member. But it is in times of financial uncertainty that the odds of cries for help rise. Maybe your son or daughter has lost a job or is struggling to make the payments on a mortgage that has reset to a higher rate. Maybe your grandkid's college tuition is overdue.

Sure, you want to help. But there is no disgrace in asking yourself: Can you really afford to? If your own job is in jeopardy, you're already retired or your nest egg has taken a serious hit, throwing a financial lifeline to a family member could threaten your own security. Dipping into a shrunken portfolio to make a loan or a gift means the money won't be there to enjoy the recovery when it finally arrives.

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You may feel, though, that not only do you desire to help but that you really have no choice. Then the question becomes: Do you lend your relative the money or make an outright gift?

A family loan is a way for the Bank of Mom and Dad to provide cash at low interest rates at a time when credit is tight, says Joseph Votava Jr., president of Nixon Peabody Financial Advisors, in Washington, D.C. If you choose this route, be sure to treat the loan as a business transaction. Otherwise, the IRS could consider the transfer a taxable gift.

Generally, the IRS demands that you charge an interest rate of at least the agency's applicable federal rate. The AFR in December ranged from 1.36% for loans up to three years to 4.45% for loans with a nine-year or longer payback period. (To find the current AFR, go to www.irs.gov.) Note these exceptions: If the loan is for less than $10,000, you don't need to charge interest. Nor must you charge interest if the loan is for less than $100,000 and the borrower's investment income is less than $1,000 for the year.

What if you don't meet one of these exceptions? If you decide to give your kid a break by forgiving interest payments, the IRS can tax you as though you did receive them.

Let's say you "lend" your child $100,000 for the down payment on a house and forgive the interest. Using December's 4.45% AFR, the IRS would tax you as if you collected $4,450 in interest.

To keep things business-like, you should draw up a promissory note that includes the interest rate and the payment schedule. If you're lending money for a home purchase, be sure the loan is recorded with local officials -- showing that the loan is secured by the home itself -- so that your child or grandchild can deduct the interest paid on the loan.

Making a loan doesn't guarantee you'll ever see your money again. Consider whether your kids or grandkids have the resources to pay you back, and whether it will strain the relationship if they don't.

David Porter, 52, made it clear to his 33-year-old son and 27-year-old daughter-in-law that he expected to get back every penny of the $27,000 he lent them. Porter, a business owner who lives in Scottsdale, Ariz., is charging 10% interest to match what he expected to receive in the stock market on that sum.

Porter's son and daughter-in-law borrowed the money to buy equipment for the thriving quilting business they own. They turned to Dad when they failed to get a bank loan. "We want to see them do well, and we want to help them out," Porter says.

But Porter also wanted to treat the loan as a formal business transaction. Although he could have downloaded the documents from the Internet or hired a lawyer, he decided to enlist Virgin Money (www.virginmoneyus.com), in Waltham, Mass.

For a one-time fee of $299, the company created the promissory note and set up a lien. "If they default on the loan, then that equipment is mine. I can sell it to recoup at least part of my money," says Porter. For an additional $9 each month, the company deducts payments from the kids' bank account, transfers the money into Porter's account, and issues monthly and annual statements. He started receiving monthly payments of $880 in August.

Giving a Gift

Parents who plan to make an outright gift to help out a family member need to be up to speed on federal gift-tax rules. You can make an annual gift of up to $13,000 in 2009 to any number of people each year without having to file a gift-tax return. For gifts above the annual tax-free level, you have to file a gift-tax return, but no tax is due until the total of those gifts exceeds $1 million.

If a family member needs immediate help, writing a check may be the best option. And note that the $13,000 tax-free level can easily be multiplied. If Mom and Dad want to give money to their daughter and her husband, the parents can give up to $52,000 (four times the $13,000 exclusion) tax-free in 2009.

However, if your child's needs are longer term, it may be a good time to transfer non-cash assets. With share prices so low, you can give away many more shares without hitting the annual or lifetime gift-tax exclusion. Your child can build more wealth by holding on to the shares until the market rebounds, says Rick Brooks, vice-president for investment management at Blankinship & Foster, in Solana Beach, Cal.

Let's say a parent has stocks and mutual funds that had been worth $1.5 million but are now valued at $500,000. The parent gives the depreciated assets to a child, reducing the parent's taxable estate. The child can profit when the market recovers.

If, instead, the parent gives the asset after it returns to $1.5 million, the parent would owe gift tax on $500,000 of the transfer, assuming that the parent hasn't used up the $1 million gift-tax credit.

Proceed carefully if you want to help with your grandchild's college costs. First, find out whether he or she is applying for financial aid. A gift from someone other than a parent could count as income for the student and reduce financial need by 50% of the gift's value, says C. Gary Hoffman, president of the Capital Group of Virginia, in Charlottesville, Va.

Also hold off on writing a check to cover part of the tuition bill. "If a grandchild was going to receive a scholarship based on need, and if the grandparent were to make a direct payment to the college, that amount would be deducted from the scholarship," says Hoffman.

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