The right way to give your kids money (and 2 very wrong ways)
It’s the question that 80 per cent of financial adviser Scott Quinlan’s older clients ask him at their first meeting. And if they don’t mention it, he does.
“They ask, ‘How much can we give to the kids to help them into their first home?’” says Quinlan, the co-founder of Brisbane-based Solace Financial. Their second question, he says, is “How do we structure it so that we don’t run out of money before pine box day?”
The consequences of getting it wrong can be costly. If you give too little, you risk making your children struggle more than they need and reduce your overall family wealth. If you give too much, even if you’re wealthy, you could struggle to fund your retirement and even be forced to sell your home.
But if you get it right, it’s a win-win.
“It’s a deeply personal issue, and the approach depends on factors, like the level of wealth, the children’s ages and the children’s own financial position,” says Caitlin Laffey, a partner at high net wealth adviser Koda Capital. The key is “not giving too much too early so that you are not able to live the lifestyle that you intend to live yourselves”, she says.
How that might play out is illustrated by modelling done by Laffey’s colleague, James Hawthorne.
The wrong way No. 1: Giving away your spending money
Hawthorne crunched the numbers to show what can go wrong when a couple with $10 million in total assets – $6 million in their home and $4 million mostly in their superannuation – give $1 million to each of their two children.
The hypothetical couple is recently retired and has income of about $200,000 a year from their super. That amount represents 2 per cent of their total assets each year so they feel they can afford to give 20 per cent away as an early inheritance.
The graph above shows what happens if they were to take $2 million from their super as a lump sum and give it to their children. If they keep spending $200,000 a year, their money runs out in less than 14 years.
The problem is that they took the money from their income-generating assets.
They still have a decent pool of money, but they will be forced to sell their home or drastically reduce their spending to cover that gift to their children.
Hawthorne uses the chart as a lesson to show clients how unplanned giving can lead to unplanned consequences.
“It’s a really crude example, but the parents are just being too generous,” Hawthorne says. “They are not looking after themselves first. A lot of the time it’s our job to say to very generous parents like these: Stop. Just make sure that you can continue to live the way that you deserve to live.”
Hawthorne says he would advise the clients in this situation to consider downsizing their home soon after or around the time they give the money.
Alternatively, the parents could consider initially giving a smaller amount or (if they have multiple children) giving one their share of the money before the others.
“You do not want to eat into your income assets too early,” Hawthorne says.
That’s a point echoed by family office adviser Lipman Burgon & Partners’ Jason Rademan, who provided his own modelling for another big risk that we’ll get to later.
“If there is any risk that a proposed gift could compromise the parents’ future ability to meet their own living expenses, it often makes sense to stage the assistance in several tranches rather than making one large, irreversible payment,” he says. “That way, parents can review their position over time and adjust the level of support if markets or personal circumstances change.”
Another solution might be to structure such a gift at least partly as an interest-paying loan.
How a loan instead of a gift might solve the problem
The main advantage of loaning the money – even if it is a no-interest loan – instead of gifting it comes down to asset protection.
When you make a loan, you still have ultimate control of the money. That means that should anyone make a claim against your child’s assets, it won’t be counted as belonging to them. This is particularly relevant in the case of a divorce or partnership breakdown but also applies to business dealings.
“When you structure support as a gift without conditions, you forfeit any ability to protect that capital,” says Paul Green, director at Vincents Private Wealth.
Loans are also assets of the estate, which is useful if your children don’t need help at the same time, Solace Financial’s Quinlan says.
“If the kids are different ages, they have different needs,” he says.
“Say Johnny is 25 and ready to buy his first home, but Mary is 17, and she might be less mature, and might not buy a home until she’s 30.
“So we do it as a loan, which helps to equalise the will. If Mum and Dad pass away, then that debt forms part of the will – Johnny has to repay his loan or it’s forgiven out of the estate and Mary isn’t penalised.”
Sometimes, it can make sense to give it as a gift outright, Quinlan adds. That can be particularly beneficial if you are planning to access the Centrelink age pension at some stage because after five years, loans are not counted in the means test.
Some families view wealth from a broader, multi-generation perspective. Quinlan gives the example of a client whose child could afford to buy an $800,000 home, but would prefer a $1.4 million home.
If the child were to buy the $800,000 home and then, a few years later when their cashflow was greater, upgrade to the $1.4 million home, Green says they would pay at extra $125,000 in stamp duty and legal fees. That’s a net cost to the family’s total wealth. But if the child was given or lent that extra $600,000, the family is $125,000 wealthier.
“Everyone sees that the entire family is much better off … the children are on their way and there’s plenty of blue sky ahead of them.”
How charging interest can help you and the kids
If you don’t have the capacity to give the full amount, then an interest-bearing loan can also result in a win for parents and children.
If you don’t look at wealth across the generations, and focus exclusively on the needs of the parents, a responsible financial adviser would normally recommend that anything from 30 to 40 per cent of their wealth should be allocated to fixed income.
Assuming a couple had $3 million or $4 million, that could amount to about $1 million in low-growth, income-producing assets, Green from Vincents says.
If the parents loaned that money to their children – making it the fixed interest part of their portfolio – that could substantially improve the wealth of the whole family because it will transform an income asset for the parents into a growth asset (property) for the children meaning both benefit over time.
If the interest rate charged was set at the midpoint between what the children would have to pay a bank and what the parents could get on a term deposit, the win-win is obvious.
Another way to handle that kind of help could be to deposit money in your child’s home loan offset account.
If a term deposit was paying 4 per cent interest and your child was paying 6 per cent interest on their home loan, some parents might ask to be paid 5 per cent for parking their money in the offset account, Quinlan says.
“The kids aren’t paying as much interest on their loan because it’s sitting in the offset and mum and dad are getting a better interest rate than what they would on their term deposit.”
Or you could capitalise the interest, says Green – meaning the interest would be added to the loan and not repaid until the asset was sold or the parents died.
This strategy could be useful when a couple has more than one child. The other children who did not get the loan would not lose out financially as the loan amount, with the added interest included, could be deducted from the child’s share of the parents’ estate.
In all the above cases, proper documentation would mean the parents could get access to the capital if they needed it. Which brings us to the second big mistake parents can make: not preparing for a market crash.
The wrong way No. 2: Not preparing for sequencing risk
One of the big risks when you move from a salary to living off your savings is sequencing risk. That’s the term for the risk of a market crash in any given year.
If a crash happens early on in retirement that can significantly reduce the capital you have to generate income in the following year. Modelling from Allianz shows that a 10 per cent drop in the value of your investments in one year means you need to generate 11.1 per cent the next year to recover the lost value.
Lipman Burgon’s Rademan gives the following scenarios to show what happens when a couple with $8 million in total assets wants to give $500,000 to each of their two children.
The modelling assumes their primary residence is worth $4 million, they have an investment property worth $1 million with a net yield of 2 per cent and $3 million combined in superannuation pensions. Their annual living expenses are $120,000 (indexed at 3 per cent inflation).
If they don’t give anything to their children, after adjusting for inflation their net investible assets of $4 million – their super and their investment property – will be worth more than the $4 million they started with in real terms even if they live to 99. So that’s a big inheritance for their children, especially when you add back in their house.
If they withdraw $1 million between them from their super when they retire at 67 and give it to their children, assuming growth of 4 per cent, the Lipman Burgon modelling shows they remain able to fund their living expenses.
But when that is stress tested with a 40 per cent market crash in the second year of retirement, the couple’s super will run out at 95, meaning they have a cash shortfall that the investment property cannot make up.
“Good giving tends to come from assets that are truly surplus to the parents’ long-term needs and is structured with an eye to sequencing risk and flexibility, rather than simply dipping into whichever pot of money is easiest to access at the time,” Rademan says.
On the other hand, if they sold their investment property at the beginning rather than took the money out of their super, they will always have income surplus to their requirements and can still fully fund their lifestyle even at 99.
Don’t be afraid to attach strings to any loan or gift
If your children are serious about building wealth, they won’t resent any conditions you attach to the loan – like not using it to buy business class flights for a holiday, or even matching the interest rate to movements in the cash rate – says Green.
While the “strings” you add might not be enforceable in court, Green says in his experience it rarely comes to that.
“Almost exclusively kids are just eternally grateful, and they understand the culture in which the money’s being lent, and they generally buy into it.
“If they understand the bigger picture, they’re likely to understand that even from a completely self-interested view, if they don’t toe the line somewhat, there might not be as much coming out down the track.”
Green will show a child – in their late 20s or early 30s – modelling that shows if they accept the money lent with whatever strings attached that “their superannuation at the end of their life is going to be worth half a million dollars more in today’s dollars and that they’ll pay off their house after 15 years”, they are more than happy to accept the strings.
Win-win.
