We are in the midst of an unprecedented financial situation. While economists debate whether to call it a depression, a recession or something else entirely, it’s evident that the days of easy credit are over (at least for now). Banks are reluctant to lend money not only to individuals, but to each other. The resulting credit crunch has implications that could stall our economy or even send us back to the days of the barter system.
While Treasury Secretary Henry Paulson is confident that the $700-billion bailout plan passed by Congress will be an effective solution, the financial markets clearly don’t agree. The immediate response of markets to the passage of the bill was a virtual freefall of stock exchanges around the globe. The Federal Reserve’s purchase of commercial debt and distressed securities did nothing to stanch the bleeding. To get the economy moving again, we need to stimulate lending by increasing banks’ financial liquidity.
There is another source of liquidity that Congress has not examined and which could be used without putting taxpayers at further risk. That source is the more than $18 trillion that is now sitting untapped and untaxed in pension funds. Encouraging retirees — through favorable tax treatment — to withdraw limited sums from their retirement funds each year to pay down existing mortgages would work to the benefit of the government, the mortgage industry and the taxpayers.
Currently, when a retiree withdraws money from a retirement account, that amount is taxed as ordinary income. (Appreciation in the value of the account’s assets is not taxed until it is withdrawn.) Retirees over age 70½ are required to make minimum annual withdrawals, even if they have sufficient income from Social Security or other investments to meet their living expenses.
I propose that a retiree be allowed to use part of the required minimum withdrawal to pay down the mortgage on a primary or secondary residence and the amount so applied be taxed at a lower tax rate — say, the 15% capital gains rate rather than a 28% or 35% marginal rate for ordinary income. Retirees who needed the entire annual minimum distribution for living expenses could make an additional withdrawal to pay down their mortgages and receive the same favorable tax rate on that amount.
As an added inducement, the amount applied to discharge of a mortgage also could be excluded from income in determining the taxability of Social Security benefits. For younger retirees, the amount of a withdrawal applied to accelerated mortgage payments could be “banked” and applied to their future required distributions after they turn 70½.
As an example of how such a plan might work, assume that Mr. and Ms. Retired live in a home with a balance of $100,000 on their 30-year mortgage, which has 10 years to run. Assume also that they have taxable income of $5,000 and $30,000 in Social Security benefits. The Retireds are both over 70½ years old and their required minimum distribution from retirement plans is $80,000.
Assuming that they don’t need the entire $80,000 for living expenses, they could apply $25,000 per year on their mortgage and pay it off in four years. Instead of paying their regular tax rate on the entire $80,000 withdrawal, they would pay a lower rate on the $25,000 applied to the mortgage.
The advantages of such a plan are significant:
1. Accelerating mortgage payoffs means that banks would receive funds much sooner than the end of the amortization period, thus increasing liquidity. The banks could then write new mortgages, lending out the funds at rates likely higher than obtained when the original mortgages were written. Not only would the mortgage industry benefit, but the renewed availability of mortgages would stimulate the besieged housing industry.
2. Accelerating mortgage payoffs also serves the desirable social goal of increasing home equity in a way that is more stabilizing than the faux equity generated by the housing bubble, which has since evaporated.
3. While retirees who accelerate withdrawals from their retirement funds would forgo some appreciation in the value of their accounts and also would be paying taxes sooner on some portion of the funds, this would be offset by the lower tax rate and by interest savings from prepaying the mortgage. Retirees who prepay their mortgage with part of the minimum annual distribution would benefit from the lower tax rate.
4. Even though a portion of the withdrawals would be taxed at a lower rate than ordinary income, the accelerated distribution of retirement funds would generate net increased tax revenues in the short term, when they are most needed to pay for actions the government is taking under the bailout program.
There is precedent for adjusting the tax treatment of distributions to retirees. Congress has at various times since 1942 subjected retirement distributions to ordinary income rates, capital gains rates and five-, seven- and 10-year averaging treatment, before returning to the present ordinary income treatment.
Also, there is more recent precedent for preferential use of distributions in the so-called direct charitable rollover rules, which were in effect for the 2006 and 2007 tax years. The provision, which lapsed at the end of 2007, allowed distributions up to $100,000 from retirement plans to be directed to certain charitable recipients. Such distributions would not be subject to itemization and other limitations on charitable deductions, and would count against the donor’s required minimum distribution. From all reports, use of the direct charitable rollover was gathering momentum and was having a beneficial effect on charitable support.
If this experience is any indication, favorable tax treatment of retirement fund distributions could be a powerful tool for injecting additional liquidity into the mortgage industry.
Prof. Sheldon Frankel teaches federal taxation at Seattle University School of Law.
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