Home-Sale Tax Break May Change

QUESTION: I am 55 years old and I am thinking about selling my house. Has there been any talk about changing the tax policies with regard to non-taxation of capital gains on the sale of personal residences after age 55? If there has been, I will put my house up for sale immediately.--A.G.W.

ANSWER: There has been more than talk. A bill authored by Sen. Bill Bradley (D-N.J.) and Rep. Richard Gephardt (D-Mo.) proposes to retain the one-time exclusion of capital gains on the sale of a principal residence but only to the extent of 14 cents on the dollar.

Here’s how that would work. Say you qualify for the maximum one-time exclusion of $125,000 in gains. Under current law, you would save in unpaid taxes $62,500--50 cents on the dollar--if you are in the 50% tax bracket, or $50,000--40 cents on the dollar--if you are in the 40% bracket.

Under the Bradley-Gephardt tax proposal, your maximum savings would be $17,500, or 14 cents on the dollar, regardless of your tax bracket. That is because, in the stated interest of fairness, the lawmakers want to eliminate all but the most popular deductions and ensure that all the remaining ones are worth the same to all taxpayers, regardless of whether they are in the 14%, 26% or 30% brackets, which are the only three proposed by the Bradley-Gephardt bill.

The best-known tax-reform plan, the Treasury Department’s tax simplification proposal, wouldn’t alter the current exclusion rules.

Current law enables taxpayers over age 55 to take the exclusion if they sell the home they used as their principal residence for at least three of the last five years. The exclusion may be used in conjunction with any earlier deferral of capital gains on the sale and purchase of a residence.

Q: Why is the government permitted to tax the interest on tax-free income when it is withdrawn from an individual retirement account? My friends and I would like to start IRAs and we were considering putting our $2,000 into tax-exempt money-market funds or bond funds until we heard that the entire investment--the original contributions and the interest earned--would be taxed as ordinary income when the funds are withdrawn.--R.S.

A: IRAs were conceived as tax-deferral shelters to encourage savings for retirement. They were not designed as tax-exempt investments.

So, if you determine that a tax-free investment is a more lucrative option for you than a tax-deferred investment, why not put your $2,000 in the tax-free instrument and forget about the IRA for the time being? Or, if you have the money to spare, why not save both ways? After all, tax-free means just what it says, so you don’t need the protection from immediate taxation that an IRA provides.

The laws allowing taxpayers to save for retirement in IRAs are built on the theory that requiring the eventual payment of ordinary income is a small enough price to pay for the opportunity to build up funds tax-free over what are in theory your best-earning (and, therefore, highest tax-paying) years. Underlying that theory is this assumption: If you could do better, you would; and if you can’t, taxation as ordinary income after years of tax-free buildup is a good deal, even if the investment would merit more favorable tax treatment outside an IRA.

Capital gains have their own favorable treatment, for example, as do tax-exempt investments. Investors, therefore, don’t need the additional incentive of tax deferral to invest in such instruments, the theory goes. Thus, both would be taxed as ordinary income upon withdrawal from an IRA.

The bottom line for savers is that, where IRAs are concerned, some investments are more appropriate than others.

As we have seen, tax-exempt securities aren’t appropriate for an IRA. And life insurance, tangible personal property and investments that produce so-called unrelated business income (operating a business inside an IRA, for example) aren’t allowed at all. Tangible personal property, better known as collectibles, includes such items as coins, antiques and stamps. They aren’t allowed to be put into an IRA because Congress says they divert money from productive capital formation. Life insurance isn’t considered appropriate for tax-deferred retirement savings because there is something perverse about investing in an instrument designed to aid survivors of the deceased when your goal is to set aside money for the living.

Your question also raises an interesting point about tax-exempt securities as an alternative to tax-deferred IRAs. Depending on your tax bracket, the annual difference between the two can add up to a huge sum by retirement.

Say, for example, you are 45 and plan to begin withdrawing funds for retirement at age 65. After 20 years of investing $2,000 at the beginning of each year at an 11% yield, you would accumulate $142,530. If you are in the 40% tax bracket now, upon retirement--you may be in a lower bracket at retirement, but let’s assume for simplicity’s sake that you aren’t--you would pay taxes of $57,012 on that accumulation, leaving you spendable income of $85,518.

Given the same circumstances but with a tax-free investment, your spendable income would be $142,530 at 11%. Even with a yield as low as 8%, your tax-free investment would still give you more spendable income--$87,730.

Another point to remember when shopping for an IRA is that a mere percentage point difference in the yield offerings can make a huge difference over several years. Take this example from Robert P. Miller of the Westlake Village office of Prudential-Bache Securities Inc.: A 30-year-old taxpayer invests $2,000 in an IRA at the beginning of each of the next 35 years. Upon retirement at age 65, he would have accumulated $758,329 at an 11% yield, $966,926 at a 12% yield and $1,235,499 at a 13% yield. If he had just 10 years until retirement, he would, given the same circumstances, accumulate $37,123 at 11%, $39,309 at 12% and $41,629 at 13%.

Debra Whitefield cannot answer mail individually but will respond in this column to financial questions of general interest. Do not telephone. Write to Money Talk, Business Section, The Times, Times Mirror Square, Los Angeles 90053.