Loaning Money to Your Child
A promissory note is a written pledge to pay a set sum at a set time or on demand.
Piggybank on It
There's a very good reason to put a loan to your child in writing. Should your child default and you're unable to collect, you'll be able to write off the loan as a non-business bad debt on your income tax return. Without proof of the loan, your deduction may be lost.
Make It Formal
When kids get a little older and want more than just an advance of $5 or $20, you may not want to keep things casual. A big advance on an allowance or a loan to buy a big-ticket item should be treated formally.
- Put it in writing. Make your child sign statement about what has been loaned to him. This statement is really a type of promissory note in which he agrees to repay the amount stated.
- Set a repayment schedule. You can leave the time for repayment open-ended or can make the loan payable on demand when you say so. It's probably a better idea to set a timetable for repaying the loan, though, so your child doesn't overlook this obligation. Don't leave the debt to be repaid “when he has the money.” Require him to make small repayments (or to forgo a portion of his allowance) on certain dates.
If your child is borrowing from you to pay college expenses, you might not want to start repayment until after graduation. By then, he'll be working full-time.
- Charge interest. If the loan is going to run for more than just a few weeks, it can be a good learning experience to charge interest. You won't get rich on the interest, but your child will see the real cost of borrowing. How much should you charge? You don't want to make the interest too low, because it's not realistic. Nor do you want to make it too high. It's probably a good idea to use the commercial rate being charged on a personal loan in your area. To find out the going rate, just call your neighborhood bank or look at ads in the local newspaper. Remember that the purpose of the interest isn't to create an income for you, but to teach a lesson to your child.
Piggybank on It
Adults who take loans receive coupon books or get billed monthly to remind them of their obligation. If you're making a loan to your child, consider using some mechanism to track repayments. Notations on a calendar may be enough of a reminder.
Imputed interest is interest income that the lender is treated as having received, and the lender can be taxed on this amount even though it's only a fiction created by the tax law.
Keep in mind that the tax law may treat you as if you had charged interest even if you make the loan interest-free. Under so-called imputed interest rules, a lender is treated as receiving interest that he effectively waived by not charging.
If the lender makes a low-interest loan, he's treated as receiving the difference between the amount charged and what the government thinks should have been charged. The amount of interest is based on applicable federal interest rate (AFR) at the time the loan is made. That rate changes every month, and there are different rates for loans of three years or less (short-term), loans of three to nine years (mid-term), and loans over nine years or more (long-term). However, no interest is imputed to the lender in two situations:
- $10,000 gift loan. If the amount of loans between the lender and borrower—you and your child—isn't more than $10,000, there's no imputed interest as long as the money isn't used to buy income-producing assets (such as stocks or CDs).
- $100,000 gift loan. If the amount of loans between you and your child is no more than $100,000, there's no imputed interest as long as your child's net investment income isn't more than $1,000. For example, if you make an interest-free loan of $25,000 that your child uses for college, there's no imputed interest to you as long as your child's interest, dividends, and capital gains do not exceed $1,000.
More on: Money and Kids
Excerpted from The Complete Idiot's Guide to Money-Smart Kids © 1999 by Barbara Weltman. All rights reserved including the right of reproduction in whole or in part in any form. Used by arrangement with Alpha Books, a member of Penguin Group (USA) Inc.
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