Using intrafamily loans in your estate plan
Interest rates are still at historic lows, despite an expected Federal Reserve rate hike. At times like these, families have a unique opportunity to transfer wealth via an intrafamily loan.
An intrafamily loan is a way for family members to loan money to each other at a special rate. They might be used to help a relative buy a house or finance a startup, for example. But for some families, they’re a tool to transfer assets outside the lifetime gift tax exemption.
When making an intrafamily loan, interest rates are typically lower than those from commercial lenders. However, the IRS sets an Applicable Federal Rate (AFR) each month that would be the lowest allowable rate.
Let’s say you provide your grandson with a $100,000 loan for five years at 1.4% (the AFR for February 2022). Your grandson invests that money and earns a return of 8%. At the end of the loan period, your grandson retains nearly $40,000 in returns, after paying principal and interest.
Bigger loans, of course, have the potential to yield bigger returns. (A $1 million loan for five years at 6% could generate more than $330,000 in returns.) No matter how big the loan, it won’t impact your lifetime gift tax exemption — provided the recipient does, in fact, pay it back.
Because intrafamily loans are typically made at lower interest rates, your relative will pay less overall than going through a traditional lender. Meanwhile, the interest you receive could exceed the rate you’d get out of a CD or money market fund.
Intrafamily loans must be properly executed to avoid negative tax consequences such as gift tax or taxable income. Establish the appropriate paper trail and demonstrate an intention to collect. If the loan goes into default, you’ll need to take legal steps toward collection or begin forgiving the loan using your annual gift tax exclusion (for 2022, up to $16,000 per recipient, double if your spouse joins in the gift), if possible.
Intrafamily loans can be tricky from both an emotional and legal standpoint. Work with an estate planning attorney to safeguard your loan and your tax plans.
Strategies for gifting to grandchildren
Making financial gifts to your grandkids can be a great way to help your descendants get a good start in life. Depending on the size of your estate, it may also be a tool to maximize gifts to your heirs while reducing the taxes due upon your death.
Before giving, be sure you understand the tax consequences of your gifts. Here are some options and tips to think about before you give:
- Know the tax rules. You can give each grandchild up to $16,000 a year (in 2022) without creating a taxable event. Two grandparents together can give up to $32,000 per grandchild (or any recipient) per year with no reporting requirements.
For example, a married couple with six grandchildren may give away up to $192,000 per year without gift tax implications. If you have a large estate and expect to exceed the federal estate tax exemption ($12.06 million in 2022, $24.12 million per couple), maxing out your annual exclusion gifts can be one strategy to optimize your wealth transfer.
If you’re thinking about gifts as a way to get money out of your estate, start planning now. The $12 million estate tax exemption is set to revert to $6 million in 2026.
Of course, you need to keep enough for your own needs. Grandparents who could potentially deplete their estates with long-term care needs should know that any gifts can interfere with their Medicaid eligibility for up to five years. If that’s your situation, planning for after-death gifts may be a better option.
- Talk to the grandchild’s parents first. Communicate with your kids before making a large gift to your grandchildren. Your kids may have strong feelings about how much financial support their children should have, and when. Likewise, they may have insight into a grandchild’s problem spending issues or even legal challenges that they’ve kept private from you.
- Paying for college. If your goal is to put money away for a grandchild’s education, 529 plans are a tax-advantaged way to do that. Be aware, you can also make unlimited payments for tuition and medical expenses for anyone you like, with no estate tax consequences. Just be sure you pay the school or healthcare provider directly.
- UTMA or UGMA accounts. UTMA and UGMA accounts are taxable investment accounts set up to benefit a minor, but controlled by an adult custodian until the child reaches a certain age, between 18 to 21, depending on what state they live in. Money in these accounts can be used in any way for the child.
- IRAs. As a grandparent, you can open an IRA for your grandchild and help them get a start on retirement savings. To be eligible, your grandchild must have earned money during the year. You can contribute as much as they earn, annually, up to $6,000.
- Trusts. Giving to grandchildren through a trust can offer you more flexibility and control over how those funds are distributed. One of the advantages of a trust is that you can work with an attorney to draft guidelines on when the income and principal will be available to the grandchild and/or how the money can be used.
Gifting strategies will vary considerably by family. To determine the best way to provide for your grandchildren, consult an estate planning attorney.