Two Loans Are Different Animals

Q. My home is worth $280,000 and is nearly paid off. I have no other debts. I also face losing my largest tax shelter: home mortgage interest. My daughter is starting college this summer and needs financial assistance. Are we better off getting a home equity loan or student loans?

--G.E.W.

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A. This is not entirely a tax matter. You must first consider seriously the extent of your commitment to paying for your daughter's education. You may intend to pay one way or the other but you also need to consider how your choice affects your overall financial situation. We'll return to that issue in a moment.

From a family financial standpoint, the home equity loan has more tax advantages, at least under current tax laws. Interest on student loans is not deductible while interest on home equity loans, including second mortgages, is currently deductible to the extent that these nonpurchase borrowings on your home do not exceed $100,000. This $100,000 figure does not include the amount of your home purchase debt, your first mortgage. It includes only any debt you have taken on and for which you are pledging your home as collateral.

What does this mean to you? Since you apparently have only a first mortgage, it means that you could get a second mortgage or a home equity line of credit and deduct the interest on a loan of up to $100,000. The fact that your first mortgage is nearly paid off does not affect your ability to deduct the interest on the loan. It does, of course, have an impact on your ability to qualify for a new loan and make the necessary payments.

Be aware, however, that many tax law reforms under consideration in Washington would limit or eliminate deductions of mortgage and equity interest. There is a fair amount of uncertainty about what will be the final result, but it would not be surprising, for example, if the mortgage deduction is preserved, but the $100,000 home equity ceiling could be lowered to $20,000 or less. Maybe it would apply retroactively to your loan. Another issue is that student loan rates are normally capped; home equity loan rates might rise in inflationary times.

Returning to the commitment issue, you need to remember that student loans and home equity loans are different animals.

Although you might co-sign some of your daughter's student loans and thus be responsible if she cannot pay later on, generally student loans are paid off over many years by the student who benefited from the education. Some loans might be entirely her responsibility. For the equity loan, you put your house up for collateral. If for any reason you cannot pay the loan back, you could lose your home. Presumably, your daughter would help you out in such a situation--if she could.

Tax-Sheltered Account Funds Subject to Taxes

Q. What happens at retirement when a taxpayer withdraws funds from a 403(b) account that has been invested in U.S. securities? Are the funds subject to taxation by both the federal and state governments even though they would not be subject to state taxes otherwise?

--J.J.

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A. All funds withdrawn from tax-sheltered accounts, such as 401(k) and 403(b), are subject to taxation by both the state and federal governments regardless of their type of investment or holding. There are no exceptions.

Why? Because these funds were not taxed before they were deposited in the tax-sheltered account and the government wants its due.

The fact that government securities, which are normally exempt from state taxes, are subject to state taxes upon redemption from a tax-sheltered account is just one of the "anomalies" involving such accounts. It is also one of the principal reasons financial planners advise us not to invest our 401(k), IRA or 403(b) accounts in government securities or any other tax-protected security.

Why, they argue rather convincingly, should you accept the traditionally lower rates of return offered by such tax-protected securities as Treasury bonds, when you can't make use of that tax advantage in a tax-sheltered account? It just doesn't make sense, they argue; and they're right.

Many taxpayers believe U.S. securities that are backed by the full faith and credit of the federal government are inherently safer than other investments and hence they're willing "to pay" for this security in the form of lower returns.

However, remember that you can get this same safety from other investments that offer better returns than government securities. By the way, many retirement funds invested in what their investors commonly refer to as "government securities" are actually held in Government National Mortgage Assn. bonds. Earnings from Ginnie Mae bonds are subject to both state and federal taxes even when they are held by individuals.

Finally, before getting upset that the government taxes withdrawals from tax-sheltered retirement savings plans even when the accounts are in tax-free investments, consider what Tom Lancaster, of Royal Alliance Associates, a Lake Forest retirement planning group, points out: Tax-sheltered savings plans held in investments generating capital gains are, upon withdrawal, subject to the ordinary income tax rate of the taxpayer--not the capital gains tax rate.

For most taxpayers, the capital gains rate, 28%, is the same as their ordinary income tax rate. But higher-earning taxpayers pay taxes on their tax-sheltered account withdrawals at their usual income tax rate, which can be as high as 39.6%.

If it makes you feel better, the value of deferring federal income and capital gains taxes--allowing you to earn interest on all your interest and gains for years and years--remains remarkably valuable in building up your retirement nest egg, given likely tax levels when making withdrawals.

Carla Lazzareschi cannot answer mail individually but will respond in this column to financial questions of general interest. Write to Money Talk, Business Section, Los Angeles Times, Times Mirror Square, Los Angeles, CA 90053. Or send e-mail to carla .lazzareschi@latimes.com

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