Tax Reform Shortens Time Needed to Be Vested
QUESTION: I have worked for five years for a large corporation that has a profit-sharing trust plan that only the company contributes to. The vesting requirement for this plan is 10 years of service with the company. I understand that the 1986 tax reform act requires full vesting of employees after only five years of service as of Jan. 1, 1989. Does this mean I will be completely vested in my plan by January, 1989?--A. R.
ANSWER: Based on the information you have provided, it is still unclear how the new law will affect you precisely. However, it is clear that the law will in some way shorten your wait for full participation, or “vesting,” in your company’s profit-sharing plan.
The new law offers two alternative schedules for employees to become vested in a company’s retirement or profit-sharing plan. One says that an employee will be fully covered after a maximum of five years of employment. The second, a “three-to-seven schedule,” says that a worker is 20% vested after three years and earns the remaining 80% in equal increments over the next four years. After seven years, the worker is fully vested. With some limitations, a company may choose either schedule for its pension plan.
Being fully vested in a retirement or profit-sharing plan is important because it allows workers to withdraw their account balances when they leave a company, either when they take another job or retire. By imposing a maximum five-year or seven-year vesting period, the law will help many employees become fully eligible for the pensions and other benefits that companies set aside for them, even if they should leave the firm before retiring.
However, a word of warning: Even though you have already worked five years for your company, in order to be covered by the new vesting law, you must be on your company’s payroll as of the first day of your retirement plan’s 1989 fiscal year. If you quit before that date, you stand to receive no retirement benefits.
Q: My wife and I have a single-family home that we have used as a rental since 1976. We owe about $20,000 on the mortgage, which carries a fixed rate of 8%. The house is now worth about $150,000. My wife intends to retire in about five years. I intend to continue working for another 15 to 20 years. We are considering the possibility of selling the house and asking for a $20,000 down payment that we would use to repay the mortgage. We would then carry back the first trust deed. We think this might be a good source of monthly income, particularly since my wife will be leaving the work force. Please discuss the pros and cons of our strategy.--L. S.
A: We took your question to a couple of financial planners, including Michael Blue of Encino, who thinks your overall strategy makes sense. He says that financing the purchase for your buyer provides you with a constant source of income and allows you to defer taking--and being taxed on--the full sales price. He also notes that the interest rate you can command for the loan will probably exceed what you could earn if you invested the money in a certificate of deposit or other savings account.
On the negative side, tax attorney Carl Swadan of the Los Angeles office of Morrison & Foerster says you are tying up your money at a fixed interest rate without an inflation hedge. Further, he says that the interest income you earn on the note is taxable while you may be more interested in investing the sale proceeds in such tax-free instruments as municipal bonds or a California municipal bond mutual fund. “You should take back paper only when it’s tough to sell the house,” Swadan says, summing up his view of seller financing.
However, if you do decide to take back the note, Blue urges you to require a down payment of at least $30,000--or 20% of the purchase price--to make sure that your buyers have sufficient equity in the house. Without such a stake, the buyers might be tempted to walk away if they couldn’t keep up with the payments. You should also carefully evaluate the credit-worthiness of your buyers to ensure that they are able to handle the loan payments. Your broker should be able to run a credit check for you.
Finally, you should make sure that you are prepared to handle a loan default, if it should arise. This means that you should be prepared to live without the loan repayment income for up to six or more months and be ready to step in and repossess the house and pay those attendant charges. Although many sellers do finance the sale of their homes with absolutely no hassle, you should at least be familiar with the worst-case scenario in the event it should come to pass.
An item in last week’s column dealing with the $125,000 real estate tax exemption available to senior citizens contained an error. Let’s clear it up.
A reader said he was selling his home and expected a total profit of $215,000. He wanted to know if he could completely avoid taxation on those profits by taking the $125,000 tax exemption available to senior citizens and apply the remaining $90,000 to a new residence.
Unfortunately, the reader did not provide sufficient information to offer a full answer. However, a general answer is that in order to avoid taxation on the profits, the homeowner must buy a new home whose price is equal to or greater than the “adjusted sales price” of the original home. In this case, the “adjusted sales price” is calculated by subtracting from the full sales price the following three items: the selling commission and related costs; allowable repair costs, and the $125,000 exclusion.
So, in the case of our reader, we’ll assume that the $215,000 is the profit after subtracting sales and repair costs. By subtracting the $125,000 exemption, the adjusted sales price would be $90,000. By purchasing a home worth $90,000 or more within two years, he could avoid paying taxes on that portion of his profit.
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.
