Bank on Your Children’s Retirement
Transition of interest rates for transitions in life
- The historically low interest rates we’ve enjoyed since the start of the Great Recession are finally starting to creep up.
- If you’re considering an important rate-sensitive transaction in your life, now is the time to act.
- Being a friendly family “banker” can be a great estate and retirement planning strategy that also helps the next generation—just make sure you consult a financial advisor about the pros and cons first.
As many of you are aware, interest rates have been at historical lows for quite some time—levels we haven’t seen in generations. But, that’s starting to change and you don’t want to procrastinate if you’re thinking of taking advantage of these historically low rates.
For example, if you are considering a loan to a family member now—a child, niece or nephew–you can do so at rates that are very, very low. The government has what’s called applicable federal rates (AFR). And, a November rate for a long-term loan–a loan out to 30 years–is only 3.37 percent.
So, I want you to follow this strategy. Suppose you could make a loan to a child, niece or nephew that also allows them to invest the savings that they earned by borrowing from you (as opposed to holding a traditional mortgage). This way, they could put the savings into a 401k, for instance, where it’s tax deductible and tax deferred until they take it out for retirement 30 years down the line.
Real world example
Suppose a young person in your family buys a $300,000 home. Now, typically 20 percent down gives them a conventional mortgage at a rate of about 4.25 percent for 30 years on the 240,000 principal outstanding. That comes out to $14,168 of principal and interest payments on an annual basis.
Now suppose you offer to loan the young couple the $240,000 to pay off their mortgage loan outright. And, suppose you make your loan interest-only, not amortized, at the current rate, of 3.37 percent. This is an arms’ length rate that the government puts out. So, there’s no gifting or estate tax issues here, which makes it really clean between you and the young people who received your loan.
Now, your 3.37 percent rate described above comes out to a total cost of $8,088 a year. That’s a lot better than $14,168 and, if you subtract the two loan terms, the young people end up saving $6,080 a year. But, it doesn’t stop there, because if they then take $6,080 in savings every year and put it into a 401k, which is pre-tax, and they use that 30 percent tax savings, they can put away $8,685 a year (about $724 per month).
Even better, suppose they take the $724 a month and put that amount away for 30 years at an average annual return of seven percent. At the end of 30 years that money grows to approximately $883,056. It’s huge!
Now, at this point, the conventional mortgage would be paid off. The $240,000 would have gone away to zero. So let’s just say for argument’s sake, that you decide at that point to pay the mortgage off and just take all the money out necessary to do that. Well, at a 40 percent tax bracket, we take $400,000–60 percent of which is $240,000–and we pay off the loan, now, in the same place, in both scenarios as far as the house is concerned, free of a mortgage.
Reducing expenses while saving for retirement
However, your child, niece or nephew now has almost half a million dollars more in a retirement account. That’s pretty huge and there are still more benefits.
If you’re retired, you probably need income, so you can make a loan in the form of government or corporate bonds bought through mutual funds or ETFs. Or, you could loan it to your children, nieces or nephews. So, there’s really a bond. It’s a friendly loan. Your kids or young relatives are paying you interest. You’re living off the interest and it’s all within the family. You’re not dealing with an outside institution. The young people are reducing their expenses and you have some leverage over them to ensure that the savings from their reduced expenses are not wasted frivolously. On the flip side, the young loan recipients have a friendly bank on their side, so if they get into trouble, lose a job (or jobs), they can make late payments to their “banker” and not worry about foreclose on their new home.
Even better, your kids or relatives still get the mortgage interest deduction right off the bat. And they build up this great retirement pad which is especially important to a generation that does not expect to see Social Security from the government or benefits from corporations like older generations do. They already know they have to save for themselves.
If this “transition of interest rates” strategy is something you can take advantage of, it’s a great way to help the next generation in your family. But, being a “friendly banker” is more complex than you might think. Make sure you consult with your trusted advisor first to talk about the estate issues, the income tax issues, the cash flow issues and other related items. You can also call us if you’d like. We’d love to go through the pros and cons of this transaction with you. So until next time, enjoy. Gary
Coyle@coylefinancial.com | 1-800-480-7913
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