Editor’s note: This is the final article in a six-part series focused on paying for education using smart financial and estate planning. See below for links to the previous articles, about direct tuition payments, 529 plans, Coverdell education savings accounts, UTMAs and irrevocable trusts.
Student loans are a common way to fund education, but many may not realize family members can be the source of these loans, not just the federal government or a financial institution. While it is less common, structuring an intrafamily loan may be the best way to help pay for education. This is especially true in periods when the intrafamily interest rates are low.
For it to be considered an intrafamily loan and not a gift, the interest charged must be at least the minimum Applicable Federal Rate (AFR) set by the IRS each month. If the AFR rate is lower than the federal student loan rate, this may be a nice alternative if you want to help a family member while not paying for their education with a gift.
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The lending family member can set the terms of the loan, structuring in as much or as little flexibility as desired into the repayment plan. If at any time the lender forgives part or all of the loan, any amount of loan forgiveness converts the loan into a gift, making it subject to federal gift tax laws. The interest earned from the loan is taxable to the lender and is not considered deductible for the borrower.
Unlike formal loan agreements with a financial institution, intrafamily loans can avoid the hassle of a credit check and extensive paperwork, making them more accessible for those with limited credit history or income. Additionally, the loan can be refinanced at any time. The downside, however, is that they may lack legal protections or recourse mechanisms in case of default or disputes. Any breach of trust could strain or, at worst, destroy family relationships.
Benefits of intrafamily loans:
- Intrafamily loans are often issued at lower rates than federal student loans (but must meet IRS-set AFR rate)
- Payment plan can be flexible depending on the terms set by the lending family member
- Avoids the hassle of bank bureaucracy and extensive loan paperwork
Considerations to keep in mind:
- Loan forgiveness converts the loan into a gift, making it subject to federal gift tax laws
- May lead to family disharmony if the loan is not repaid
Exploring intrafamily loans for education funding offers a flexible and possibly lower-cost alternative to traditional student loans. By meeting IRS-set interest rates and customizing repayment terms, you can provide financial support while avoiding the hassle of a bank or federal student loan program. However, keep in mind the risk of tax implications and possible strain on family relationships if the loan is not repaid. Weighing these factors can help you decide if an intrafamily loan is the right choice for your situation.
Conclusion to the series
There are myriad ways to fund a child’s education, and there is no one-size-fits-all solution ― each family should consider their financial situation, tax situation, estate plan, investment plan and/or family/personal dynamics to determine what is best.
Here’s a snapshot of the six options we’ve discussed in this series:
| Row 0 - Cell 0 | Direct Tuition Payments | 529 Plan | Coverdell ESA | UTMA | Trust | Family Loan |
| Tax-free growth of investments | No | Yes | Yes | No | No | No |
| Contributions are subject to gift tax | No | Yes | Yes | Yes | Yes | Yes, if forgiven |
| Can pay only for specific education expenses | Yes | Yes | Yes | No | No | No |
| Contribution limits | No | Yes | Yes | No | No | No |
| May reduce financial aid | Yes | Yes | Yes | Yes | Yes | No |
Many families use a combination of methods and vehicles for funding education, especially when multiple generations are involved. For instance, parents may set up a 529 plan to pay for their children’s college education, while the grandparents pay for private secondary education by making tuition payments directly to the school.
As an investment office serving multigenerational families, all with different circumstances, we are happy to help you explore your options for paying to educate future generations.
Other Articles in This Series
- Part one: Direct Tuition Payments: A Tax-Efficient Way to Pay for School
- Part two: 529 Plans: A Powerful Way to Tackle Rising Education Costs
- Part three: Coverdell Education Savings Accounts: A Deep Dive
- Part four: UTMA: A Flexible Alternative for Education Expenses and More
- Part five: How an Irrevocable Trust Could Pay for Education
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