Finding a home for your nest egg

Say you're one of America's IRA-rich couples, and you have a million or two socked away in these qualified retirement plans. You are in this situation because you changed employers and rolled over a pension plan from your old firm, or firms, into an IRA.

These days you're awfully nervous about having that nest egg in equities. Retirement looms close, and you'd like to keep at least some of your money clear of the bumptious telecommunications revolution. So you're in cash, and you're looking for other safe places. You crave security.

Why not buy another nest with your nest egg? After all, that shingled cottage on the shore may lose some value if they build a Home Depot at the traffic circle, but it is not likely to lose 50 per cent of its value in a day, the way the cable modem maker Terayon Communications did this week. Sure, there may be a real estate bubble, but it is hard to believe the residential market in the US will go through the gyrations that stocks have.

But actually you can't use your nest egg for a second nest. The laws governing America's tax-protected plans explicitly prohibit such a move.

Most IRA owners are aware of this sad reality. But it is worth pointing out that the rule is awfully counterintuitive. After all, says Blanche Lark Christerson, director at Deutsche Bank Private Banking, the old rule is "buy what you know". And let's face it: many of us know a whole lot more about zoning laws and property taxes in our favourite ski region than we do about Bernie Ebbers or the politics of corporate governance at the WorldComs of the world.

We might have pretended to ourselves that we knew about Celera Genomics (or any other stock that built up our IRA). But a lot of those gains were dumb luck and an economy far more predictable than that in America today.

Moreover, a second home would actually give us the advantage of being able to use and enjoy our investment, something no equity can offer. Add to the mix that creepy post-September 11 feeling that keeps you tossing for a few minutes each night - that feeling that says you need a haven, emotional and financial, outside the big city.

Still, "cracking open" your IRA probably isn't worth it, especially if you are younger than the infamous IRA cut-off age of 59-and-a-half. If you choose to withdraw IRA money to buy your second home, you are subject to ordinary income taxes, plus a nasty 10 per cent penalty. This means, in high-tax venues, that many taxpayers would receive only 40 cents on the dollar they withdraw.

This frustrating state of affairs is due to our old notions of savings and consumption. Savings, the tax culture says, are good, and it tends to define equities in IRAs as savings. Consumption is bad. A house is consumption, so it is not available to the IRA investor.

But the IRA's framers, and those of other such plans, never realised the portfolios would get this big. After all, when the modern IRA was created two decades ago, citizens were limited to a $2,000-a-year contribution.

Still, for the same reason an IRA is valuable to a higher earner, a second home is also valuable. That reason is taxes. Say you go ahead and borrow for your second home, using your net worth, which includes the IRA money, as collateral. If you take out some form of home equity loan, the interest is tax deductible. The tax break is so important that borrowing makes sense.

It is perverse that our system encourages someone close to senior citizenship to increase his debts. But it is tax reality.

As Michael Graetz, Yale Law School's tax sage, points out, things could be worse. After all, in tax theory, consumption can be taxed. When our homes appreciate in value, we're profiting from that increase, and so could conceivably be taxed on this imputed income.

In some Western countries (not this one) the theory has some reality. Until 1963, Britain taxed the imputed income on homes. The US Treasury has thought about this matter as well, a fact which came to the attention of television host David Brinkley. About a decade ago, he complained aloud that the government calculated "how much they could take away, if they decided to".

Navigating the tax world of second-home ownership is always going to be difficult: renting out your vacation place for 13 days brings you income that is untaxed, but a 15-day rental's revenue is subject to ordinary rates.

Still, perhaps the best thing Americans can do at this point is accept second-home reality and run with the new mortgage.

There is a very good reason that the basic law allowing deductibility of interest on second home mortgages is not likely to disappear. That is that just about every member of Congress has, or wants to have, two homes, one in Washington and one in his home district.

And these days, that fact is about the safest kind of market guarantee you can get.

© Copyright 2002 Financial Times

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