Borrow from family to cut out the bank - the plan sounds simple, but it may be a wolf in sheep's clothing. Photo / Getty Images
COMMENT:
Q: I was talking to my retired parents (in their 70s) the other weekend about the lower interest rates and their declining income.
It occurred to us that instead of them investing their money in institutions they could "invest" it with us. We could pay them a higher rate than they currently receive and we could pay a lower rate than we currently pay on our mortgage.
For example, a one-year deposit rate is about 2.7 per cent and a one-year mortgage rate is 3.6 per cent. So we could split the difference at, say, 3.15 per cent. We could reset this every year.
Could they gift us a lump sum and then we could gift them back 3.15 per cent as a table-type loan?
Or could my parents pay me the money, and I pay off my current mortgage? Then I put the repayments to my parents into one of my current accounts and give them a card to access the money. So it doesn't physically transfer to them.
That way they get the full 3.15 per cent with no tax taken out, as they aren't receiving any income as such. So no need to declare it, as they are just spending money out of my account.
Could this possibly be considered as tax avoidance? I like to think of it as minimisation and helping my parents out.
Should they require a lump sum for any reason, we could then take out a mortgage if necessary. Our current loan:value ratio is under 50 per cent.
It would seem to benefit both parties. What else should be considered? Thank you for your time and wisdom.
A: This reply actually draws on the wisdom of many readers of this column. More on that shortly.
But first, let's look at the tax situation, where I'm afraid your creature in sheep's clothing has been revealed as a wolf.
Inland Revenue is not impressed with your creative thinking. A spokesperson's response to your letter starts with the usual: "The scenario as described by your reader is a little complicated and we would always encourage people to get clear tax advice from a tax agent, using their specific tax situation and details, before going ahead. That should include advice on any penalties which apply to underpayment of tax."
But then she gives us a bit of guidance on your gift idea: "As you know, IR doesn't give tax advice, but the thinking is this might not qualify as a gift, because of the agreements surrounding it.
"It is most likely a debt arrangement, and some of the payments could be interest and subject to tax."
She continues: "In the second case, where the repayments are simply 'made available' to the parents through a current account they are able to draw from, in our view those deposits into the current account would still be interest paid and the interest must be calculated and tax paid."
That settles that. If you want to stay legal, your parents had better declare the interest they receive.
But still, there's an advantage in cutting out the middle bank. And given that there's no way to get around the tax situation, you might as well make it a straightforward loan that you repay just like a mortgage.
What else do you need to consider?
About 10 years ago, I ran a similar letter in the column. Over several weeks, readers wrote in discussing different aspects of family loans. Here's a summary of our collective wisdom.
You should get a lawyer to draw up a contract. Anything less might seem fine now, but might not work well down the track.
But first, it's time for a family conference, where you need to discuss these possibilities:
• What would happen if you or your partner — or both of you — lost your jobs or had health problems and were unable to make payments for a period?
• Is it possible that someone could sue you or your partner and you lost your house? If that happened, what would happen to your debt to your parents?
• What if you, your partner or one or both of your parents died or became incapacitated while the loan was still outstanding? If your parents died, the outstanding loan could perhaps be deducted from your inheritance.
You've already addressed a couple of other possible problems, by saying you could easily get another mortgage if necessary. But other readers should also consider these situations:
• What if your marriage or partnership ended and your partner wanted to stay in the house while you moved elsewhere? Would your parents be willing to leave their money in the house? If not, would your partner be able to get a new mortgage?
• What if your parents decided, after a while, that they wanted to spend the money, perhaps on a health problem or family financial crisis?
All these issues should be covered in the contract. If they are hard to discuss now, they would be even harder when things go wrong.
Another important point: have you got siblings? If so, could they be offered the same deal? I've seen many families torn apart by charges of favouritism, quite often emerging after the parents have died. Ideally, all the siblings would know about a family loan and agree to it.
You also need to discuss the terms of the loan. How will you handle changes in mortgage and term-deposit interest rates? If they all rise, for example, will the interest your parents charge also rise? And specifically, which rates will you use in these calculations? Maybe the ones offered by your banks.
Once you've discussed all this, approach a lawyer with expertise in this area. She or he might have useful suggestions and can make the loan official.
It is all worth it? It depends on the difference between the deposit and mortgage interest rates, and on the size of the loan. Currently the difference in rates is not big. But if you're borrowing several hundred thousand dollars, it might still work.
Q: I have wondered why I can't get a truly growth KiwiSaver fund. Even Simplicity Growth has about 20 per cent in fixed interest. I have more than 25 years to retirement and would like a KiwiSaver that is 100 per cent shares.
Are there any? Why not? In the long term — 25 years-plus — I believe shares are fine with my risk profile, but the KiwiSaver system does not seem to offer anything.
A: You're quite right that a fund investing fully in shares is a good idea over many years, as long as you can tolerate severe downturns. If the balance of your account halved, would you stick with that fund? If yes, go with it.
It's not true, though, that KiwiSaver doesn't offer such funds. Go to Smart Investor on the Sorted website. Click "Compare" at the top, and then compare KiwiSaver funds.
That tool defines growth funds as holding 63 to 90 per cent growth assets — which are shares or property. But then there are aggressive funds, with 90 per cent or more growth assets, so click on "Aggressive".
Scroll down a bit, and you can sort the funds by the amount of growth assets or fees or returns. If you choose "Growth assets (highest first)", you'll find several funds that are so close to 100 per cent shares it doesn't matter.
I suggest you don't select on that basis, though. Check out the aggressive funds with the lowest fees. They are your best bet to deliver the highest after-fee returns over your 25 years.
Q: I was wondering if there are any rules around calling a KiwiSaver fund "conservative", "balanced" or "growth".That is, where these terms are used by different providers, do they provide a similar investment profile?
A: There are no rules, but generally conservative funds are similar, and so on.
The best way to compare funds of the same type is in the Smart Investor tool described in the previous Q&A. In it:
• Defensive funds have less than 10 per cent growth assets.
• Conservative funds have 10 to 35 per cent.
• Balanced funds have 35 to 63 per cent.
• For growth and aggressive funds, see above.
That means that if, for example, a fund calls itself "balanced" but currently has less than 35 per cent in growth assets, it will be compared with conservative funds.
Q: In a recent column you refer to "being on the top tax rate of 33 per cent".
No one — as in no one — is on the top tax rate of 33 per cent in NZ. You should have referred to the top marginal rate of 33 per cent!
Maybe it's time to remind readers of the differences between marginal and actual tax rates.
Here are some actual tax rates for different taxable incomes:
• On $50,000 the tax is $8020. So the tax rate is about 16 per cent.
• On $100,000 the tax is $23,920. So the tax rate is 24 per cent.
• On $150,000 the tax is $40,420. So the tax rate is 27 per cent.
• On $250,000 the tax is $73,420. So the tax rate is 29 per cent.
Personal income tax rates for $100,000 incomes at 24 per cent are actually quite low by world standards.
Many pensioners on $50,000, made up of NZ Super and an investment income, are only paying 16 per cent.
Keep up the good work — financial literacy is important for everyone.
A: My first response to your letter was, "You're being pedantic! Everyone knows that when we say someone is on the top tax rate of 33 per cent, that rate applies only to the last dollars they earn."
But then I thought, "Perhaps they don't". So here's your letter.
Personal income tax rates in New Zealand are:
• 10.5 per cent of the first $14,000 you earn.
• 17.5 per cent of every dollar between $14,000 and $48,000.
• 30 per cent of every dollar between $48,000 and $70,000.
• 33 per cent of every dollar over $70,000.
That means, as you point out, that even someone on a really high income pays less than 33 per cent in total.
Nevertheless, people commonly talk about being in a certain tax bracket. For example, if their income is above $70,000, they are in the 33 per cent bracket.
Let's say such a person is looking at term-deposit interest. While they will have paid lower tax on their income up to $70,000, they will pay 33 per cent tax on the interest.
That's the context in which I wrote, two weeks ago: "Let's go back to our deposit earning 12 per cent. If you were in the 33 per cent tax bracket back then, tax would have reduced your interest to 8 per cent."
Sure, I could have written, "If you were in the 33 per cent marginal tax bracket ..." But there's another issue here. The more words I use like "marginal", the more readers who don't mix in your and my world will think, "I don't understand that financial jargon", and stop reading.
Sometimes it's better to write the way everyone talks, even if it's not strictly accurate.
If you're a woman with a money question, send it to mary@maryholm.com by the end of Monday and it will be considered for next week's column. Late letters will be considered for future columns, as usual.
- Mary Holm is a freelance journalist, a seminar presenter and a bestselling author on personal finance. She is a director of Financial Services Complaints Ltd (FSCL) and a former director of the Financial Markets Authority. Her opinions are personal, and do not reflect the position of any organisation in which she holds office. Mary's advice is of a general nature, and she is not responsible for any loss that any reader may suffer from following it. Send questions to mary@maryholm.com or click here. Letters should not exceed 200 words. We won't publish your name. Please provide a (preferably daytime) phone number. Unfortunately, Mary cannot answer all questions, correspond directly with readers, or give financial advice.
OPINION: You need to consider interest, taxes and fees.