| Here's what Ben had to say about our housing savings
idea: Hey, Martha. I've been thinking about your home-savings idea, and think I've spotted a problem. At that point they pay income taxes on the contents of the account, but those tax obligations are offset by the tax advantages that our legal system routinely grants to homeowners. I'm afraid that this is an inapprorpiate use for a deferred-taxation account like you describe, because home purchasers would be pulling all their money out as a lump sum to purchase their house during a year in which they're likely to also have ordinary income. Since this would be a taxable event, they would pay income taxes on the lump, but this causes a spike in their income that year. Thanks to progressive taxation, the lump would be taxed at a higher rate than the amounts they saved would have been. Assume you have a married couple making a static income of $50,000 a year, who wish to purchase a modest house in Austin in a good-but-not-ritzy neighborhood (say $120,000). They wish to accumulate something close to $25,000 so that they'll have around a 20% down payment. They figure that they can save 5,000 pre-tax dollars a year. Let's assume 5% interest on their savings. Current system: Year 1: $5000 pre-tax - 15% income tax =4250 saved + 5% Interest on $0 = 0 - 15% tax on interest = 0 Balance = 4250.00 Year 2: $5000 pre-tax - 15% income tax -> 4250 saved + 4.25% tax-adjusted interest on $4250 = 180.62 Balance = 8680.62 Year 3: $5000 pre-tax - 15% income tax -> 4250 saved + 4.25% tax-adjusted interest on $8680.62 = 368.93 Balance = 13299.55 Year 4: $5000 pre-tax - 15% income tax -> 4250 saved + 4.25% tax-adjusted interest on $13299.55 = 565.23 Balance = 18114.78 Year 5: $5000 pre-tax - 15% income tax -> 4250 saved + 4.25% tax-adjusted interest on $ 18114.78 = 769.88 Balance = 23134.66 Year 6: $5000 pre-tax - 15% income tax -> 4250 saved + 4.25% tax-adjusted interest on $ 23134.66 = 983.22 Balance = 28367.88 If the couple withdraws their savings after year 5, they pay no taxes on that withdrawal and can spend 23134.66 on a home purchase. The same applies after year 6, when they can spend 28367.88 on a home purchase. Bridegam system: Year 1: $5000 pre-tax = 5000 saved + 5% pre-tax interest on $ 0 = 0 Balance = 5000 Year 2: $5000 pre-tax = 5000 saved + 5% pre-tax interest on $ 5000 = 250 Balance = 10250 Year 3: $5000 pre-tax = 5000 saved + 5% pre-tax interest on $ 10250 = 512.50 Balance = 15762.50 Year 4: $5000 pre-tax = 5000 saved + 5% pre-tax interest on $ 15762.50 = 788.12 Balance = 21550.62 Year 5: $5000 pre-tax = 5000 saved + 5% pre-tax interest on $21550.62 = 1077.53 Balance = 27628.15 Year 6: $5000 pre-tax = 5000 saved + 5% pre-tax interest on $ 27628.15 = 1381.40 Balance = 34009.55 Growth of the account is much faster, isn't it? But what happens when the couple pays the deferred taxes on the account? For year 5, they withdraw 27628.15. For tax purposes, this is added to their income taxes on $50,000, making their yearly income 77,628.15. Since the cutoff between the 15% bracket and the 25% bracket is at 58,100 for MFJ couples, the first $8,100 of the 27628.15 will be taxed at 15%, and the remaining 19528.15 will be taxed at 25%. 1215.00 + 4882.03 = total deferred tax liability on their savings of 6097.03. This means that at year 5, they will be able to spend 21531.12 on their home purchase, compared to 23134.66 under the current system. For year 6, they withdraw 34009.55. For tax purposes, this is added to their income taxes on $50,000, making their yearly income 84009.55. Since the cutoff between the 15% bracket and the 25% bracket is at 58,100 for MFJ couples, the first $8,100 of the 34009.55 will be taxed at 15%, and the remaining 25909.55 will be taxed at 25%. 1215.00 + 6477.38 = total deferred tax liability on their savings of 7692.38. This means that at year 6, they will be able to spend 26317.17 on their home purchase, compared to 28367.88 under the current system. The reason that tax deferred accounts work so well for retirees is because retirees rarely have larger incomes when they make their withdrawals than when they made their deposits, so progressive taxation works in their favor. This does not apply to first-time homeowners -- usually the opposite is true, in fact. Probably a good option would be something structured more like a Roth IRA. I think that it does have some provision for home purchases, but they may be piddly. -Ben ....and later: Two more notes: If the couple were low enough in their tax bracket that withdrawing their savings didn't push them into another one, or if the progressive tax system were replaced with a flat tax system (i.e. if none of their savings were taxed at a higher rate at withdrawal then at savings), they actually would come out slightly ahead with the proposed system: Year 5 would yield 23483.93 compared with 23134.66 under the current system Year 6 would yield 28908.12 compared with 28367.88 under the current system I suspect that this is due to the effects of compounding. If I were them, though, I wouldn't view a 1.5% (non-annual) gain on their savings to be worth the lower liquidity of a designated-use account. Also, an important assumption in my scenario is that the couple has a static income. If their income rises over the 5-6 years they're saving (as is likely), it's possible that all their savings will be taxed at the higher rate when they withdraw it. -Ben ...and further: ...Sara and I were talking about home savings accounts last night, and had a few observations: 1) Plenty of programs exist to extend credit to people who haven't saved enough to make a 10-20% down payment. FHA loans do this, as do some of the veterans loans -- they extend credit to people who only have 5% saved up. This has not necessarily proven to be beneficial, and I've seen it cited as another variety of the overextension of credit that's been fueling bankruptcies, albeit a more benevolently intended one than aggressive credit card offers. Your general idea of helping people acquire substantial down payments seems like a much better solution than the lower-down-payment approach, since a larger down payment really reduces risk to the homeowner. I've seen plenty of situations after the dot-com bust in which people lost their jobs and were in quite a bit of trouble because their home value had also dropped. In order to sell their house they actually had to cough up money, since they owed more on their mortgage than they could sell the house for. In one of these examples, a friend of mine wasn't able to look for work at a different city because of being tied to his house. In another, some friends had to clean out their savings in order to sell their house and move away. Having a larger down payment might have reduced the cost to them -- not in delta-net-worth terms, but in terms of cash flow for people who were out of work. 2) Deferred taxation accounts aren't a good vehicle for home savings. But what is? People saving for houses are likely to make mid-term investments in savings accounts, CDs, money-market funds, or bonds. All these tend to pay interest, rather than dividends or capital gains. Perhaps you could allow people to designate an account as a home-purchase account and allow any interest accrued to be tax-free? -Ben |