Helping Adult Children Financially: Part 5 - Retirement

When Baby Boomers started their working lives, retirement pensions were more common. However, starting in the 1970s, the IRA and 401(k) revolution kicked off the transition away from defined benefit plans (pensions) to defined contribution plans like 401(k)s. These latter plans put the onus on individual workers to manage their retirement finances. Although Boomers were caught in the transition, they benefited from a long-term bull market that supercharged their savings.

Post-Boomer generations have not been so fortunate. Pensions have become less common, and the stock market has been less favorable. It’s no wonder these generations lag in building adequate retirement nest eggs.

As a result, parents may want to help by contributing to their adult child’s retirement funds, especially early in their offspring’s earning years, when it might be more difficult for them to find the extra money to stash away. Experts agree that the earlier retirement savings begin, the more likely it is to reach end-of-career financial goals.

There are several ways to help.

Roth IRAs

A great way to help kick off a retirement saving program is by contributing to a child’s Roth IRA early in their working life, even before they become adults. A custodial Roth IRA can be opened as soon as taxable income is earned. The annual maximum Roth contribution amount is $6,500 (in 2023), or the total of the child’s earned income for the year, whichever is less.

The word “custodial” indicates the Roth IRA is set up with another person (usually a parent) before the child reaches eighteen (or 21 in some states). While the minor child owns the account, the custodian makes contributions and handles investment decisions. When the child reaches the age of majority, the account is transferred to a regular Roth IRA solely in their name.

IRA rules allow others to make deposits into someone’s Roth IRA so parents can directly contribute to their children’s accounts. This would be considered “gift” money. However, if it is the only annual monetary gift to the child, then gift tax reporting is not an issue since the maximum IRA contribution is below the reporting threshold.

The advantage of a Roth IRA is that earnings are not taxed upon withdrawal because contributions were made with after-tax money. A logical question is, “Why not contribute to a traditional IRA with pre-tax dollars?” That way, taxes are avoided today because individuals can deduct contributions from their taxable earnings. Then, when they withdraw the money in the future, they pay taxes at the prevailing rate. However, because most young people are in lower tax brackets, such a deduction would have a low impact, making a Roth IRA a better bet.

401(k) Plans

Of all types of retirement plans, Americans are most likely (35%) to have a 401(k)-type account. Offered by employers to their workers, 401(k)s come in two flavors like IRAs: traditional and Roth. Like IRAs, 401(k)s allow contributions up to an annual limit. Also, like IRAs, traditional 401(k)s are funded with pre-tax dollars and Roths with after-tax dollars. They differ from IRAs because employers can match employee contributions up to a certain annual amount. Such a benefit can be a big incentive for employees to contribute at least up to the match amount.

A 401(k) also differs from an IRA because only the employee and employer can contribute. Even so, parents can gift money with the understanding that the adult child then makes 401(k) contributions up to an amount that triggers the full employer match.

Maximum annual 401(k) employee contributions for 2023 is $22,500. Depending on the employer match amount, a parent’s gift could reach the gift tax reporting threshold of $17,000 for 2023.

Non-Qualified Retirement Savings

Financial planners recommend that some of one’s retirement savings be in “non-qualified” accounts. Such non-IRA/non-401(k) accounts have no tax advantages. There is no tax break when contributions are made, and withdrawals are taxable at the prevailing rates when withdrawn.

Savers often wonder why retirement dollars would not be 100% invested in tax-advantaged qualified accounts. Experts cite these four reasons for doing this:

1. For workers who do not have access to 401(k) accounts, using IRAs only typically won’t allow enough money to be saved due to annual contribution limits.
2. Nonqualified accounts have no contribution limits, so those who have maxed out their annual IRA/401(k) accounts can save more.
3. Non-qualified accounts have substantially fewer rules so that money can be accessed quickly for emergency “non-retirement” purposes.
4. Having some funds in non-qualified accounts allows more flexibility in tailoring a withdrawal strategy during retirement since pre-tax (401(k)/IRA), Roth, and non-qualified accounts experience different tax treatment upon withdrawal.

Since there is no limit to how much money can be deposited in a non-qualified account, parents must keep the gift tax reporting limits in mind.

Parents contributing to the retirement fund for a child of any age is a grand gesture of support toward a child’s future financial security. Some parents may be more open to such monetary support because it delivers benefits far in the uncertain future. It also allows parents to help in areas that adult children may be forced to skimp on in their early earning years. Parents can help their children leverage many more years of account growth than would otherwise have been possible.

One caveat is that parents need to honestly discuss with their children the intention for the money to be untouched until retirement. There could be a great deal of temptation for adult children to tap into the money before retirement despite the financial penalties. However, parents also need to accept that they ultimately do not have control over the money once it is gifted. They can hope their generous gesture will be respected and the money will remain an important part of the child’s retirement nest egg.