Teach Children Financial Responsibility

As the year draws closer to an end, many parents will consider making gifts to their adult children.  Part of that gift giving conversation should include a discussion of how to manage money and how to responsibly invest.  Before making gifts of any significance, parents could consider the following three key elements of successful financial responsibility: (1) budgeting, (2) preparing for the unexpected, and (3) sound investments.

Budgeting

The term “budgeting” might evoke thoughts of restriction rather than control.  But the name of the game is really understanding how one’s money is being allocated among wants and needs. 

Unless a child has a handle on that concept, or is naturally averse to spending beyond the child’s needs, it is unlikely that any sizeable gift will become the legacy that it could be.  Part of creating a legacy with the gift is, certainly, tied to the goal of the parent.  If the money is meant to pay tuition, then saving that money is not the legacy—the education is the legacy.  Beyond such targeted outcomes, however, budgeting is essential if the parent wants the gift to grow through investments.  Most financial advisers can help in the process, such as competent certified financial planners (CFPs) or certified public accountants (CPAs) with a personal financial specialist (PFS) designation, if the parent is unsure how to start that conversation.

Preparing for the Unexpected

The easiest route for making significant gifts is to make those gifts outright.  There is certainly merit to simplicity.  But if a simplicity tail wags the gift giving dog, other important benefits may be lost. 

First, the child should be encouraged to plan for how to handle the gift should the child become incapacitated.  Typically, the most effective way to do that is for the child to create a revocable trust (of which the child is the initial trustee, settlor, and beneficiary), or, at a minimum, to execute a valid durable power of attorney to name someone who can step into the child’s shoes should the child become incapacitated. 

Second, the child should be encouraged to plan for an untimely death.  It is not a fun thought, and might seem like the fasted way to suck the excitement out of any gift, but addressing what happens at the child’s death is facing reality—and that is itself a useful lesson to teach.  Again, typically a revocable trust can address the issue of death, but a valid Will may also suffice.  Some securities and accounts permit the naming of beneficiaries, which can be an effective way to address what happens at death, so long as the issue of incapacity is adequately addressed as well.  

Third, the parent should consider whether protecting the gifted money from the child’s creditors is important.  In most states, a person cannot create their own trust, be the beneficiary of the trust, and have the trust property out of reach from their creditors.  In those states, however, a parent could create creditor protection for the child.  This is usually done by having the parent form an irrevocable trust (of which the child could usually be the trustee and the beneficiary).  Every state’s laws differ on these three points, so consultation with a competent attorney is usually a pre-requisite to picking the correct way to plan for unexpected events.

Sound Investments

If the intent is for a significant gift to grow into a legacy for the child, then how the gifted sum is invested is critical.  How that is accomplished likely depends on the characteristics of the parent and the child in relation to money.  If the child is a spendthrift, then making an outright gift to the child with the hope that the child will responsibly invest the funds is probably not likely to get the desired result.  Although there is no perfect method, four suggestions below (from least to most retained control over the gifted sums) might make sense.

  1. Encourage the child to consult with a competent financial advisor, such as a CFP or CPA with a PFS designation.  If the parent has a clear responsible investment philosophy of their own, then they might encourage the child to adopt the same philosophy, and explain why it is a responsible solution.
  2. Contribute the gift to a joint account with the parent, or to an account that gives the parent rights to access and view the account.  In this method, the parent can police the child’s use of a competent financial advisor or adoption of a sound family investment philosophy through access to the account.  Whether the parent would have the ability to direct or make trades on the account is up to the parent and child.  However, this would give the parent an ability to have continuing oversight of the funds to ensure that the gift was being invested and not drained for improper purposes.
  3. Alternatively, the parent who wants greater control over the funds, might consider contributing the funds to an LLC of which the child is the member and the parent and the child are the managers.  Investment decisions could require unanimous consent of the managers so that the parent would have direct involvement in how the funds are invested.  If the child is the sole member of the LLC, then the operating agreement of the LLC would need to limit the ability of the member (the child) to remove managers or amend the agreement without the managers’ consent.  A small twist on this could be to grant the parent the ability to remove and appoint managers, name the child as the sole manager, and restrict the member’s ability to remove managers and amend the operating agreement to require the parent’s consent.
  4. Finally, if the parent would prefer to have indirect control of the funds and to not just gift significant funds to a child, the parent could make a loan to the child rather than a gift.  The loan could (and should) bear at least the lowest applicable federal rate of interests to avoid unintended gifting and interest income.  The current applicable federal rate for November, 2019, for a loan of up to three years is as low as 1.68% for annually compounding interest.  All investment growth over the interest amount would pass to the child.  If the parent wanted to be able to claw back the loaned funds in case the child missed payments, the parent could loan the funds to an LLC of which the child was the member, secure the loan with the LLC membership interests, and include restrictions in the LLC operating agreement preventing distributions, liquidations, or amendments to the operating agreement while the loan is outstanding.

Conclusion

While every method above would not fit all circumstances, and this post is not meant to be an exhaustive list of options, this post should at minimum illustrate that each unique situation can typically be met with a customized solution.  Making significant gifts should be done with thoughtfulness.  An ounce of planning can yield a pound of benefits.

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