Some 401(k) Funds Can Help Buy Homes

QUESTION: I plan to buy a home in five years. In the meantime, should I avoid putting any money into an individual retirement account or 401(k) plan? I know many friends who have had to pay hefty early withdrawal penalties when they have used proceeds from these accounts for the down payments on their homes.--J. S.

ANSWER: Your best course of action depends greatly on your individual circumstances, the details of which you neglected to include. However, we can still offer some general guidance to help you evaluate your situation.

For starters, are you even sure that you qualify to make a tax-deferred contribution to an IRA? Remember, Congress rewrote the eligibility rules in 1986. Currently, only workers whose companies do not offer qualified pension plans or who make less than $35,000 as individuals or $50,000 if married are entitled to make tax-deferred IRA contributions.

You probably don’t even want to consider opening an IRA unless your contributions can be tax deferred, and even if you do qualify, pitfalls and penalties await if you withdraw your funds before age 59 1/2. In addition to being slapped with ordinary income taxes on the funds, you will be forced to pay a 10% early withdrawal penalty. By the time the dust settles, you can find yourself with far less money to use for that down payment than you originally thought. In general, our experts say you are probably better served forgetting about IRAs entirely.

However, the 401(k) plans offered by many corporations are an entirely different matter. And, depending on the rules governing the plan at your company, you might want to consider enrolling in one. In general, these plans allow employees to place a limited portion of their gross income each year in tax-deferred savings accounts that are invested and managed by their employers. This year, the maximum you can contribute is $7,627.

Although 401(k) account funds may be withdrawn without penalty only when you turn age 59 1/2 or suffer certain hardships, many companies allow their employees to borrow against their account balances. You should check if this choice is available to you and what interest rate and other fees are charged for this service.

You should also find out whether your company will match any of your 401(k) contributions. Many companies do--typically by as much as 50%--which means an employee’s account grows more rapidly than it would in another type of account paying the same interest rate.

So, the bottom line is that you must investigate the particulars of the 401(k) plan offered by your company. If you are allowed to borrow against your balance at a reasonable interest rate and fees, and if your company matches a portion of your contribution, our experts say you would be wise to run, not walk, to your employee benefits department and sign up. Otherwise, you are just as well off paying your income taxes now and saving whatever you can.

Estimated Tax Depends on Withholding

Q: I plan to sell some stock, which will give me a sizable gain before the end of the current quarter. In paying estimated tax on this gain, must I pay the full amount by Sept. 15, or can it be spread out over the balance of the year?--N. E. L.

A: Income taxes are technically due on April 15 following the tax year for which you are reporting. However, as you apparently know, both California and the federal government require taxpayers to prepay virtually all of their income taxes through a pay-as-you-go system of withholding. Taxes on income not subject to direct withholding--such as extraordinary gains from asset sales--must be paid with the filing of an estimated tax form every quarter.

How much you actually wind up paying in estimated tax on Sept. 15 depends on how close you are to meeting the withholding requirements, which are the same for both California and the federal government. By the time the year ends, you must meet at least one test of sufficient tax withholding. Either you must have at least 90% of your total tax obligation withheld during the year--and it must be done during the quarter the income was received--or you must have prepaid an amount equal to your entire federal tax obligation for the previous year. If you fail both tests, you will be hit with a penalty.

Our experts suggest that you do a quick estimate of your total tax obligation for all of 1989 as well as your total tax withholding. This should help you determine the amount you must prepay by Sept. 15 to avoid any penalty.

Divorce Won’t Change House Cost Basis

Q: My husband and I bought a house in 1954 for $25,000. In 1982, we divorced and I was awarded the house we had held as community property. Should the value of both halves of the property be set as of 1982, as it is in the event a surviving spouse inherits a deceased’s interest in their community property? I am sure others wonder as I do if the same principle applies to the death of a marriage as to the death of a spouse.--J. F. H.

A: Although the pain and sense of loss in a divorce is quite similar to that caused by the death of a spouse, the Internal Revenue Service treats the two events quite differently.

When a spouse dies, the IRS allows the survivor to value both halves of their community held property as of the spouse’s date of death, not its original cost. The net effect of this bit of largess from Congress permits the surviving spouse to realize a larger non-taxable gain when these assets are sold. (However, this is only true for assets held as community property; for those held as joint tenants or tenants in common, only the deceased’s half is valued as of the date of death.)

In the case of divorce, how the assets were held doesn’t matter. Neither half is treated to an increase in value when the marriage is dissolved; the original cost basis remains unchanged. In your case, the house you received in the settlement still has its original $25,000 cost basis.

Attorneys and accountants say that when property settlements are being worked out, they try to assign equally not only the marriage’s assets but the cost bases of those assets. And you can see why. It may do a spouse no good to receive an asset worth several hundred thousand dollars if virtually all of it is taxable upon sale.

Carla Lazzareschi cannot answer mail individually but will respond in this column to financial questions of general interest. Please do not telephone. Write to Money Talk, Business Section, Los Angeles Times, Times Mirror Square, Los Angeles, Calif. 90053.