Should you bail out your kids?

Woody Allen joked that when he went missing as a child, his parents took immediate action: They rented out his room. Joking aside, many parents are renting their kids' rooms these days—to the kids themselves.

With unemployment for Americans 18 to 24 about 16 percent and average college debt at graduation around $20,000, moving back home is the only affordable option for many young adults. Some children in their 30s and older are heading home as well, affected by job losses, divorce, debt, or health issues. Kids who are out on their own may ask for help to buy a home, car, or business, or to pay bills. Many parents struggle with how to help responsibly.

When a child seeks help, the most important step is clarifying up front what's expected from each other. "Otherwise," says Jeff Fishman, a principal of JSF Financial, a Los Angeles financial advisory firm, "it becomes a dependency situation before you even know it."

When Nick Kaye, 27, a digital artist and designer in New York City, got in over his head financially, his father, Kenneth Kaye, a Chicago-based family psychologist, worked out a deal, outlining what each would do, including consequences for unmet conditions. They chronicled the experience in a self-published book, "Trust Me: Helping Our Young Adults Financially" (iUniverse, 2009). Discipline on both sides is key, the elder Kaye maintains.

Setting reasonable boundaries is important when children move back to their parents' home, whether they're 23 and searching for a first job or 40 and bankrupt. Parents should draw up a contract of responsibilities: What chores will they do? Can they have guests, and if so, until what hour? How much will they contribute to gas, utilities, food, and rent? And when do they plan to leave?

Charging rent, even a small one, is worthwhile, says Eleanor Blayney of McLean, Va., consumer advocate for the Certified Financial Planner Board of Standards and author of "Women's Worth: Finding Your Financial Confidence" (Directions, 2010). "You're beginning to model true behavior that the person is going to have to practice in the real world," she says.

If you're concerned about your child becoming too comfortable back amid his high-school trophies and Shaq posters, make him occupy a guest room instead. And when he's ready to move to his own place, you can ease the transition by helping with the security deposit and first month's rent or paying half the rent for, say, six months.

You might have to practice tough love, says Jon Gallo, an estate attorney in Santa Monica, Calif., who with his wife, Eileen, a psychotherapist, wrote "The Financially Intelligent Parent" (Penguin USA/New American Library, 2005). The Gallos, who also offer consulting services, recall a client who set a deadline for an adult daughter to move out after living at home for months without seeking work. On that day, a moving van showed up at the house. "The parents paid for her to stay at a local motel for two weeks," Jon Gallo recalls. "She had a full-time job within 48 hours."

If you intend to give your child money, don't attach strings, experts say. "If you think a gift is corruptive, limit the amount," Blayney says. "Or sit down and have a talk about what the gift means, and under what circumstances you would ask to be repaid." Federal law allows people to give up to $13,000 a year to anyone without gift-tax consequences. Couples can give $26,000 per recipient each year.

If you decide to make a loan instead, structure it so that everyone benefits, suggests Jonathan Bergman, a certified financial planner and vice president of Palisades Hudson Financial Group in Scarsdale, N.Y. With auto loans running at 8 to 10 percent, for example, and five-year CDs paying less than 3 percent, a below-market rate of, say, 6 percent would work for both parties.

Keep in mind that the IRS requires you to report interest earned on a family loan, and if the rate is below a level set by the IRS each month you'll also need to report forgone interest on your tax return.

Outline the loan's terms in writing—principal, interest, payment due dates, and time limits. A private loan won't help build or improve your child's credit history.

Clarify the terms of a bailout as well. Ken Kaye agreed to pay Nick's rent for a year as long as his son covered other expenses and took part in regular discussions about his financial progress. Nick, in turn, agreed to stick to cash and debit cards.

Consider helping your child get a secured credit card. They're backed by a savings balance of, say, $500. Typically holders can borrow 50 percent to 100 percent of that amount. Choose a card that reports to the three major credit bureaus so your child can establish a credit history. Once he's built up a good payment record, he can apply for a regular credit card.

Parental love can have traps, especially when money's involved. Don't put your own finances at risk to help a child. Don't borrow against your home or retirement funds, for example. Use cash accounts; don't liquidate investments to help your kids. Don't establish a joint account with a child. And avoid co-signing for a credit card or a loan; if your child defaults, it's your credit score that will be pummeled.

And just as you did when your child was 6, hold your ground. "You've got to know that by holding firm to your financial boundaries," says Derrick Kinney, a chartered financial consultant in Arlington, Texas, "you're both going to be better off down the road."

Whether or not your adult child moves back in with you, she might ask you to help with expenses. The litmus test for Jon and Eileen Gallo, of Santa Monica, Calif., is whether doing so will foster more independence. They think four types of expenses fit the bill:

• Education. Paying tuition directly to a college or trade school means the money will go where it's intended. You will also sidestep limits that can reduce additional gifts you can give tax-free.
• Vocational testing. Testing services such as Highlands (www.highlandsco.com), publisher of the Highlands Ability Battery, might give your anthropology major the direction he needs. Your child could also meet with a career counselor. The National Career Development Association offers an online referral program at www.ncda.org (click on the link "Find a Counselor").
• Health insurance. The new healthcare law allows parents to cover their children on their employer-provided insurance policy until age 26, starting as soon as Sept. 23, 2010. When your children are no longer considered dependents by your group health insurer, they can extend that coverage through COBRA for three years, though the premiums are likely to be higher than under your plan. In 2014, the law says that everyone younger than 30 will be offered their own coverage or receive subsidies to buy individual coverage.
• Therapy. Psychotherapy, substance abuse treatment, or other specialized services may be essential to help your child become independent. A new federal law requires that group health insurers cover mental-health services with the same deductibles, co-pays and other limitations that they apply to most medical and surgical care.

This article appeared in Consumer Reports Money Adviser.