Parental money to Adult Children: Do Loans Work Better Than Gifts?

Financial experts are of two minds when it comes to parents assisting their adult children financially: in one sense, they want to help, on the other, they aren't sure whether to get involved at all.

"It can be a great idea or a terrible idea, depending on the circumstances," says Rebecca Pavese, a financial planner with Palisades Hudson Financial Group's Atlanta office.

No matter what, parents shouldn't let any family "financial aid" take their own long-term savings out of whack. "Never let helping your child jeopardize your retirement," Pavese says.

Perhaps the main issue with financial aid to adult children is how to structure the payout. Specifically, should the money be a gift or a loan?

Pavase comes down on the side of loans over gifts.

"It's a good way to foster both independence and responsibility for someone planning to buy a car or a home," says Pavese, who says she has helped several clients loan money to their adult children. "It's also a wise choice if you can't afford to give away a lot of money, but can afford to make a loan."

Loans over gifts have some definite advantages. "With so-called intra-family loans,' children pay less than they likely would if they borrowed from a bank, and you can earn a decent return while helping your children help themselves," Pavase adds.

Pavase offers a two-step process to get the family financial aid deal done the right away.

1. First, set the interest rate. Do not set the rate below the Applicable Federal Rate (AFR), a rate the IRS sets each month that varies based on the length of the loan. (Rates for July 2016 range from 0.71% for short-term loans, 1.43% for medium-term loans and 2.18% for long-term loans.) If you charge less than the AFR, the IRS will deem it a gift, not a loan, she says.

2. Next, set up a repayment schedule and decide in advance the penalty for your child failing to make payments on time. If your child "defaults" on a loan, there should be stated, concrete consequences, such as withholding future gifts.

Financial experts also say that parents need to go into family loan or gift situations with their eyes wide open.

"Parents need to understand that many family loans turn into grants," notes Thomas Scanlon, a certified financial planner with Raymond James, Manchester Conn. "They don't get paid back."

If making a loan to a child, start small, Scanlon says. "Perhaps start with several thousand dollars to put down on a car, for example," he says.

When you do loan or gift money to an adult child, do so smartly, with tax advantages in mind. "Wealthy families should make gifts to their children annually," Scanlon adds. "Each parent can give to each child up to $14,000 per year without having to file a gift tax return."

It's also important to understand that every child gift/loan situation is unique, says Rob Shampine, a financial advisor with Direct Financial, LLC, in Bloomfield Hills Mi.

"My experience in the matter is a mixed bag," Shampine says. "I have a client that no matter what, he will not under any circumstances give his children money. No matter how responsible and knowledgeable his children are. He has several intra-family loans established (with interest) with his children. If a child defaults, he nets the money from any inheritance they would receive via their living trust.

Shapine says he's seen extreme cases where the kids are "horrible" and have taken advantage of their parents to the tune of thousands of dollars. "In this case a more structured loan approach could've helped minimize the damage," he adds.

There's also a strong sentiment among financial services professionals to discourage parents from either gifting or loaning cash to adult children.

"As a rule, I strongly discourage parents from serving as the bank for their children either in the form of direct loans, ongoing and substantial financial gifts in the form of cash or property, the provision of rental property at a reduced rental rates, or as a cosigner on a bank loan," says Roger R. Bell, II, founder of Roger R. Bell & Company, Inc., a financial advisory firm in Dublin, Va.

More often than not, Bell says he has witnessed adult children become co-dependent upon the parent for ongoing financial needs. "Subsequently, and almost without fail, the adult child's self-esteem falters with the ancillary and serious problem of self serving behavior becoming the norm rather than the exception," Bell adds.

That's a slippery slope that children may never recover from.

"The negative fallout becomes exacerbated when the parents exercise fiscal discipline to ensure that the adult child meets their financial obligation," Bell says. "And, this negative fallout extends into the grandchildren and extended family and, further causes severe disruption to family unity for decades.

Bell provides some common sense advice to his clients considering a gift or loan to a son or daughter. "Parents must teach their children fiscal discipline by guiding them to recognize the difference between their wants and needs, living within their financial means, and saving for a future cause," he adds. "Without a doubt, parents should allow their children to experience the difficulties of life, so they can raise their own children in a manner which reflects a wise financial upbringing."

Parents must make up their own mind about giving or loaning money to an adult son or daughter. But like the experts say - only go into that situation with your eyes open, and be completely cognizant of any potential family fallout from the deal.

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