Be Careful When Making Family Loans

It’s common for parents or grandparents to lend money to adult children. It’s also common for such family loans to make everyone unhappy — the lender, the borrower, other family members . . . even the IRS.

The first clue as to whether a family loan could be trouble is the nature of the loan. A loan for the down payment on a first home or seed money for a promising business startup might be one thing. Bailing out a child or friend who’s perpetually in debt is another. Choose your loans carefully.

One way to look at a family loan is to figure it’ll never be repaid and simply chalk it up as a gift. You might even consider it an advance against the child’s inheritance. However, other family members may resent that you’re not loaning them money, too, or they may expect the family member to pay back the estate when you die. It might be a good idea to discuss any sizable loan with the other heirs to make clear why you’re lending money and whether you intend to have it paid back or whether it is an advance against their inheritance. Loaning a family member or friend money you don’t realistically expect to be paid back also can create serious tax consequences, which will be discussed shortly.

Most Certified Financial Planners® recommend that if you’re going to loan money to a family member or friend, you put the loan in writing. Be clear about the amount you’re lending, what interest you’re charging, payments, due dates, and even late fees. This benefits you and the borrower, and can help if there is any dispute with the Internal Revenue Service about the loan.

As long as the total loan is for less than $13,000, the IRS is probably not going to care about the loan. That’s because for 2011 you can gift up to $13,000 a year free of gift tax (or $26,000 if it’s a loan from a married couple). The exception to this rule is if the borrower uses the money to buy income-producing assets. Above $13,000, loans get a bit more complicated.

As you might expect, you can’t just hand a child or friend tens of thousands of dollars, call it a loan, and then simply forgive it. Otherwise, people would use “loans” to shift assets to heirs free of gift or estate tax. Consequently, any time you loan more than $10,000, you must charge an interest rate that is at least as much as a minimum IRS rate — known as the applicable federal rate. In April 1999, that rate ranged from around 5% on short-term loans (less than two years) to about 5.7% on long-term loans (over seven years). If you make an interest-free loan or charge less than the applicable federal rate (below market rates), you may have to pay income tax on the imputed interest you should have received.

For loans up to $100,000 that are not invested by the borrower, you won’t pay any tax on imputed interest as long as the borrower doesn’t earn other net investment income over $1,000. If investment income exceeds $1,000, you pay income tax only on imputed income that equals the borrower’s net investment income. For loans over $100,000, you’ll pay income taxes on the phantom interest regardless of how the money is used.

What happens if your child or friend fails to pay back the loan? First, you can always forgive up to $13,000 of the loan each year ($26,000 for married couples). Second, the IRS may try to re-characterize the loan as a gift. This is where good loan documentation can be invaluable. It also helps if there is at least some history of repayment, and if you can show efforts at trying to collect, including selling loan collateral or, heaven forbid, suing.

Clearly, loaning to family or friends should not be done casually. It may not only damage personal relationships, but also cause income tax and estate planning problems. Work with your Certified Financial Planner® and attorney to be sure everything is in order.

(Published May 2008; Revised Aug 2011)

Short Duration Funds – A Cash Alternative

This is a discussion of why, in the current interest rate environment, we prefer using short or ultra-short duration bond funds in lieu of money markets. This is a type of mutual fund that invests only in fixed-income instruments with very short-term maturities (generally around one year). An ultra-short bond fund will pursue strategies aimed at producing higher yields by investing in securities with higher risks. This investment strategy tends to offer higher yields than lower risk money market instruments, with less price fluctuations than a typical short-term fund.

In conjunction with the stimulus package, the Federal Reserve lowered the federal funds rate, which influences other short-term interest rates such as deposits, bank loans, credit card interest rates, and adjustable-rate mortgages to anywhere from 0% to .25% — the lowest in history. Because of this phenomenon, we took a look at the last 25-30 years and noted that there has traditionally been a spread of between .5% and .75% in a normal economic environment. That 50-75 basis point spread has been enough of an incentive to cross from 30-day paper – the traditional line of demarcation between a money market (be it insured or otherwise) versus a bond fund, which technically does fluctuate in principal, but usually provides an increased yield of .5% to .75%. In the current environment, that spread has been magnified up to four-fold in some cases, depending on whether the instrument is taxable or tax-free. The trade-off is the fluctuation in principal, which is generally nominal but is a rounding to the nearest penny, and thus requires either acknowledgement on Schedule D of your federal tax return or at least an awareness that the real risk is usually not credit risk but interest rate risk.

Keep in mind that ultra-short bond funds are not guaranteed or insured by the FDIC or any other government agency and can vary significantly in their risks and rewards. The level of risk depends on a variety of factors including these fundamental tenets:

1. Credit risk. From what institutions are the underlying securities or bonds issued? If they are tax-free, the mutual funds will be buying government agency debt, depending on the quality, that are expected to pay interest on a regular basis. If the credit is downgraded, it will negatively impact the principal value of the bond. Typically, high quality AAA-rated government agencies do not have frequent credit rating downgrades.

2. Interest rates. We are at the bottom of an interest rate cycle. It makes little sense to buy longer term bonds because interest rates are poised to increase. Longer duration bonds are more adversely affected than shorter duration bonds as rates rise.

Short-duration bond funds overlap so that as interest rates rise, although they may suffer a decline in net asset value (NAV), the actual yields may roll somewhat evenly. Last year was a good field test, since it was probably the worst year in history for credit markets. When we see that some short and ultra-short duration bond funds pay as a total return what they yielded as a dividend, it makes many quite attractive. This might be appropriate for you, if you are looking for higher yield opportunities than money market funds and are willing to accept greater risk. This would only be as a parking place to hold short-term primary reserves for individuals who may be in transition or to serve as the primary cash reserve as an alternative to a low or no interest-bearing cash, savings, or money market account.

A Primer on Medicare & Medigap Coverage

Despite all the public discussion about health care, very few people under the age of 65 understand the basics of Medicare, the federal health program for seniors and certain disabled individuals, or Medigap, the supplemental private coverage many buy to cover treatment that shortfalls what the federal program doesn’t pay.
Even if you have years before you qualify, why focus on Medicare and Medigap now? Because as big changes happen in our health care system, those who understand the programs and products ahead of time will not only be better equipped to plan for their post-retirement health care options, but they’ll have a better understanding of these critical federal program changes over time.

Who is eligible for Medicare? More people than you might think. Medicare is available to anyone over the age of 65 who is a U.S. citizen or a permanent legal resident for five continuous years. Yet people under the age of 65 qualify under certain circumstances, including: If they are permanently disabled and have received Social Security disability payments for the last two years, or if they need a kidney transplant, are under dialysis for permanent kidney failure or have Amyotrophic Lateral Sclerosis, also known as Lou Gehrig’s disease.

How does Medicare cover expenses? Medicare coverage is divided into three primary parts: Part A, Part B and Part D. And yes, there is a Part C. Here’s what each part covers:

• Part A is the segment of the program most associated with hospital care. It covers hospital inpatient care, a limited amount of care at some skilled nursing facilities, some specific home health care alternatives and hospice care. Most people are enrolled automatically in Part A when they reach 65 and they get this coverage for free. What’s important is that Medicare doesn’t cover long-term nursing home expenses, so that’s why long-term care planning is necessary for all individuals.

• Part B is all about outpatient services. This is the part of the plan that covers doctors’ visits, outpatient care and some other medical services that Part A doesn’t cover, such as the services of physical and occupational therapists, and other aspects of home health care. You do have to pay a monthly premium for Part B coverage with a deductible – in 2009, the basic premium is $96.40 per month though it might be higher for some people based on income. By the way, you’ll sometimes hear people refer to Part A and Part B coverage as “Original Medicare.”

• Part D is Medicare’s prescription drug coverage. Part D is administered by a number of private insurance companies that operate in various areas of the country, so this requires some shopping on your part to make sure you’re getting the right drugs at the right price. Financial assistance might be available if you need it.

• Part C is actually the Medicare Advantage Plan, which is an optional plan individuals may choose so they receive their Medicare benefits through private health plans. You’ll also hear this plan referred to as Medicare+Choice. These private plans include conventional HMOs and PPOs and are required by law to offer benefits that cover everything that Medicare covers, but they don’t have to cover everything exactly as Medicare Part A and B do. There might be some customized options that allow for lower co-payments or lower total out-of-pocket expenses. In simplest language, Medicare Advantage plans blend the benefits of Original Medicare and Medigap plans (more on this below). By law, you can’t buy Medigap supplemental insurance if you’ve chosen Medicare Advantage. However, it’s very important to get some expertise on the choice between Original Medicare and Medicare Advantage plans based on your anticipated health needs to make sure the coverage you buy covers what you really need.

What about Medigap? So-called “Medigap” coverage is supplemental coverage that’s available for people who opt to be covered under Original Medicare – Part A and B coverage. You buy Medigap insurance from a private insurer, and your primary goal is to determine whether that supplementary coverage actually pays for the things you know you’ll need that Medicare doesn’t cover. You do have to pay a monthly premium for this coverage. And again, if you choose Medicare Advantage (Part C) coverage, you’re not allowed to buy Medigap coverage.

To compare Medicare and Medigap coverage, visit the Medicare Personal Plan Finder on the Medicare.gov website.

When do I enroll for Medicare? You have a six-month window to enroll for Medicare that starts three months before your 65th birthday and ends three months after. As mentioned above, if you’re already receiving Social Security at age 65, you’ll automatically be enrolled in Part A, but if not and you enroll more than three months after your 65th, you may be subject to a late enrollment penalty.

By the way, what’s Medicaid? This is the name for the federal program – and corresponding state programs – that pick up health care costs for indigent children and adults. Unless you’re below the poverty line or you spend out your assets in your senior years, this won’t be part of the discussion.

DFSC Commentary During the Great Recession – Spring 2009

Dear Clients:

It is now the spring of 2009, and the U.S. as well as the world has been in recession for well over a year. The bear markets, which originated in the U.S., have now reached 18 months with a severity that has not been seen in over 30 years.

One must remember there is a difference between capital markets and the economy. Capital markets tend to be a very strong barometer of economic weather; they show a decline typically 6-9 months ahead of an economic downturn and similarly tend to recover 6-9 months before a recovery takes hold. The capital markets have been in decline for 18 months, making this one of the longer bear markets on record. That having been said, from March 6th through April 6th of this year the S&P 500 has rebounded over 22%. There have been 10 recessions since World War II, of which only 4 have had equal or longer bear markets: 1968 = 18 months, 1980- 1981 = 20 months, and 1973-1974 = 21 months. An exception was the last recession of 2000- 2002 in which the bear market was elongated to 31 months exacerbated by 9/11. Only time will tell if we have seen the bottom of this market.

The economy is unequivocally in recession, but not to the severity that was experienced in either 1973-74 or 1980-81 when looking at GDP declines and unemployment rates. However, the severity of this bear market is approaching some of the most virulent returns we have seen. For only the second time in 72 years, the S&P 500 was down 37% and the MSCI World Ex USA index was down 43% for 2008. Although those numbers are distressing, historically these pronounced selloffs provided the foundation for above average stock market returns going forward. Most quixotically, the 1930s have been associated with some of the worst periods in capital markets’ performance. But, that period also saw some of the best one year returns on record. For example, 1933 is not typically identified as a high-reward year, but it was one of the 5 years in the last 184 where returns were above 50%. In 1933, there were returns between 50- 60%; in 1935 returns were between 40-50%, and 1936 returns were between 30-40% depending on the market capitalizations observed.

Volatility can be unsettling when witnessed on the downside. But, historically these windows provided an opportunity for patient investors to acquire assets at attractive prices, leading to the quote from one of the sages of the past, Sir John Templeton. Even though it’s more than a decade old, it is still timely: “Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.” One would hardly argue that our nation is feeling a bit pessimistic these days.

Sincerely,

David W. Demming, CFP®

DFSC Commentary During the Great Recession – Winter 2008

Dear Clients:

As 2008 draws to a close, the US economy has been in a recession for over a year, making it one of the longest recessions we’ve had in 25 years. It is important to note that capital markets tend to lead the economy by approximately 6-9 months as a barometric indicator. As capital markets remain in a negative mode, the economy should continue in that manner also for at least that same amount of time. It may take until the first half of 2009 for the capital markets to recover, and then hopefully the economy will follow at some point in the second half of next year.

The triple witching hour of the housing bubble contributed to the financial bubble, which in turn helped usher in the current recession that started back in 2007. These forces have contributed to a comprehensive decline in most of the major markets from real estate to large cap US domestics, small caps, and pretty much across the board in overseas investments. In fact, overseas markets show declines more severe than domestic declines. However, this recession has yet to equal the depths or lengths of the recessions of 1980-81 or 1973-74, which was the greatest recession since the Great Depression.

With 2008 coming to a conclusion, the capital markets, represented most commonly by the S&P 500 and the Dow Jones 30 Industrials, will more than likely set a record of financial ineptitude. The worst decade in American history has traditionally been the 1929-1939 period in which returns were anemic, but nonetheless positive. Surprisingly, that period showed a positive return of 10% cumulatively, or 1% per year. The current period from 1998 to 2008 appears poised to set a standard for lowest economic returns for the major indices, which currently range from -20% to -30% as a cumulative 10-year return.

In 1998 we had a similar but far less severe recession that started with the collapse of Asian currencies. The US government injected significant amounts of liquidity into the system, propped up Lehman Bros., and a sharp but short recession was ended; the economy recovered within 7-8 months.

The year 2000 brought in the tech bubble and many overvaluations in the capital markets. Then in 2001 we had 9/11, with the subsequent recession in 2002. These factors contributed to a longer than normal period of recovery for the capital markets.

This current recession has created a series of events that may set new standards – the lowest, the worst, and the first negative returns for major market indices over a 10-year rolling period in eight decades.

Declines of major magnitude have usually been followed by periods of higher than average rewards. The 1980s and 1990s were a period of very high returns, which followed the decade of the ‘70s during which returns were far below average. Many market mavens suggest that current valuations portend dramatically higher-than-average rewards, not only contributing to a recovery but also establishing a new era of prosperity. We shall see.

From an economic standpoint, we will be thankful for 2008 to end and look forward to 2009 with a degree of concern but also a bit of optimism. As investors, we tend to be overly optimistic in good times and overly pessimistic in bad times. As Warren Buffett commented, “Be fearful when others are greedy, and be greedy when others are fearful.”

We wish you a happy holiday season, with hope for a more positive outlook in the coming year.

Sincerely,

David W. Demming, CFP®