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What to consider before lending money to family and friends
When your best friend views your
nest egg as a source of start-up funds for his latest business venture, or your
nephew hits you up for a car loan, your first impulse may be to reach into your
bank account to help. But it's a fact that loans to family and friends often
end up straining both finances and relationships. As Shakespeare said,
"Loan oft loses both itself and friend." In other words, if you lend
money to friends, you often don't get paid back, and the friendship itself may
disintegrate.
It's best to consider a loan to
someone you love as an "arm's length" transaction. If you're
pondering such a loan, keep the following in mind:
* You can just say "no."
It's your money, after all. Do you really want to raid an emergency fund or dip
into your child's college account to finance a friend's business idea? Think
like a bank. It's reasonable to ask tough questions about the person's bank
accounts, potential sources of income, planned use of loan proceeds, and
spending habits before extending credit.
* Consider a gift. If you're
comfortable sharing your resources, you may want to provide a monetary gift
with no strings attached. In many cases, this is the best solution because
neither you nor your friend expect the money to be paid back. Unlike a loan, this
type of arrangement can forestall misunderstandings and hurt feelings later on.
Of course, you should not give money if doing so would unduly strain your own
finances.
* Formalize loans. If you decide to
lend more than a small amount to a friend or family member, it's generally best
to draft a written agreement. This can be as simple as filling out a promissory
note (available online or at office supply stores). Such forms spell out the
basic terms of the loan -- amount, interest rate, payback period -- and provide
some limited protection should you and the borrower end up in small claims
court. Another recent innovation is the use of direct lending (also called
social lending or peer-to-peer lending) websites to facilitate loans between
family and friends. For a fee, such sites can prepare loan documentation, send
payment reminders, issue regular reports, even facilitate electronic fund
transfers. If the loan involves a significant amount of money, check with your
attorney.
Remember: Many personal relationships
have been damaged when loans go awry. So proceed with caution.
Posted in tax
For instance, though you probably know the initial borrowing
has no federal income tax effect, you might be wondering whether the interest
you pay will be deductible. In general, the answer is no. That's true even when
you use 401(k) loan proceeds for your home.
Ordinary loan repayments are not taxable events either. That
is, you don't have to pick up the interest you repay into your account as
taxable income. And, though you're increasing your 401(k) account with the
principal portion of each payment, that amount is not considered a
contribution. You can still make pre-tax contributions up to the annual limit
($17,500 for a traditional 401(k) during 2013, plus an additional $5,500 when
you're age 50 or older).
What if you default on the 401(k) loan? The balance of your
loan is considered a distribution to you, and you'll have to report it as
ordinary income on your federal tax return. In addition, when you're under age
59½, a 10% early-withdrawal penalty typically applies.
Being both a 401(k) borrower and a lender can lead to tax
surprises. Give us a call to make sure you have the whole story before you
arrange a 401(k) loan.
Last Updated by Tax on 2013-09-18 12:26:43 PM