With the new estate tax exemption limits at $5.25 million, planning for income taxes has become as important as estate planning for higher income earners. In the past, an advisor may recommend parents give money to a younger generation. While this is still a good and valuable strategy, a new strategy has emerged. Parents more frequently loan money to children for investment purposes.
For this scenario to work effectively, the younger generation will be taxed at lower income tax rates than their parents. The parent loans an amount of money to the child at a very low interest rate, which is set by the federal government. The current rates are: .32% for 0-3 year maturities; 1.78% for 3-9 year maturities and 3.50% for loans coming due more than 9 years from inception.
The children can then take this money and invest it. If they get an investment rate of return in excess of the interest rate, the child will make money over the long term. Additionally, they will pay income tax on that money at their lower income tax rate. The parents will pay income tax on the interest earned. Another benefit is, technically the parent does not give up control over the money as one would with a gift or by placing money in a trust. Of course there is still a risk. The child may not pay back the loan. So if the money is needed in the future it may not be there.
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