During and after the Great Recession, it was common to see parents providing financial assistance to their adult children. The National Endowment for Financial Education estimated in 2011 that upwards of 60% of parents provided financial support to adult children that were out of school.
But even as the economy has recovered from the lows of 2009, there are still many parents with adult children that need financial assistance, whether it be to pay their bills or to put together enough money for a down payment on a home.
It’s easy to want to immediately say yes to your children’s requests for financial help. After all, you’ll always be their parent. But before you make the decision to loan money to your adult children, consider asking yourself the following questions.
Can I afford to help?
As much as many parents truly want to help their children any way that they can, the fact is that you simply may not have the wherewithal at this moment to provide financial support. Do you have debt of your own that needs to be tackled? Are you currently on track to save enough to meet your goals for retirement? Make sure your financial house is in order before agreeing to loan money.
Why does your child need the money?
Is your child saving up for a down payment? Are they struggling to pay off student loans or medical expenses? These are costs that can be incurred by even the most financially responsible people, and it may be okay to help your children with these bills. If, however, your child is consistently incurring debt from overspending, it may be better to have a conversation to discuss what they can do to become a smarter consumer and follow a budget. Simply loaning your children the money may only encourage your child to continue to make suboptimal financial decisions.
Will the loan cause discord in your family?
When loaning money to one of your children, it’s possible that some members of your family may feel unhappy about the loan. This can be especially true if the loan amount is large or if your child is unable to pay back the loan in full. Make sure you and your spouse are in alignment when making this decision. It may also a good idea to consider the feelings of your other children as well. One solution may be to decrease the child’s portion of any inheritance if the money is considered a gift or if the loan is not repaid.
If you do decide to loan your child money, it’s important to consider whether you want to set up that assistance as a gift or whether you truly want to set it up as a loan. If you simply want to gift money to your child, keep in mind the $14,000 annual gift tax exclusion amount. Exceeding that amount could have estate tax ramifications.
For smaller loans, the IRS generally isn’t concerned with whether you charge interest or even if the loan is paid back. For larger loans, however, you’ll either need to charge interest on the loan or it will be considered a gift in the eyes of the IRS. While it can feel harsh charging your child interest, the unfortunate reality is that providing an interest-free loan could cause you to be subject to unfavorable tax rules.
Even if you do charge interest, the IRS may check to see whether the rate you’re charging exceeds the applicable federal rates (AFRs)—interest rates approved by the IRS, updated monthly, used to evaluate whether a loan is a gift or a taxable event. Providing a loan with an interest rate below the AFR could subject you to below-market interest rules, which is less than ideal. As the size of the loan increases, so too does the complexity. It may be a good idea to work with an attorney or a tax advisor to ensure you’ve structured the loan correctly.
At the end of the day, remember that it’s okay if you decide you are unable to loan your child the money he/she requested. If you are unsure of how to talk with your child about the loan, your financial advisor can provide guidance to help ensure the conversation is productive for everyone involved.