Using favorable tax treatment to blunt nation's mortgage crisis

AS the federal government debates the details of a plan to bail out corporations devastated by the mortgage crisis, taxpayers wonder how it is we can afford the $700 billion it will take to do so.

In fact, much of that sum can be raised by accelerating tax collections in a way that benefits the government, the mortgage industry and the taxpayers. With about $18 trillion sitting untapped and untaxed in pension funds, the answer lies in providing favorable tax treatment for retirees to withdraw that money to pay down existing mortgages.

Here's how it would work: Suppose Mr. and Ms. Retired own a home with a 30-year mortgage balance of $100,000 that they expect to pay off in 10 years. Their taxable incomes are $5,000 and $30,000 respectively in Social Security benefits, and they are both older than 70 ½ years old. The minimum annual distribution from their retirement plan is $80,000, and they don't need it all for living expenses.

Instead, they could apply $25,000 annually to their mortgage and pay it off in four years, and pay only 15 percent capital-gains tax on that portion of the withdrawal. The rest would continue to be taxed at the higher ordinary income rate. As an added inducement, the amount applied to a mortgage could be excluded from income used to determine the taxability of Social Security benefits.

There are many advantages to such a plan:

• Near-term tax revenues would increase thanks to the accelerated withdrawal of retirement funds.

• Banks would immediately receive funds that would enhance their liquidity. The same funds could be made available for loans, at today's higher interest rates, and stimulate the besieged housing market.

• Although the money withdrawn early from retirement plans would not earn interest, that would be more than offset by a lower tax rate.

• Homeowners would rapidly accumulate equity, countering the current downward trend in home values.

This would not be the first time Congress changed the rules for taxing distributions to retirees. Since 1942, Congress has subjected retirement distributions to: ordinary income rates; capital-gains rates; five-, seven- and 10-year averaging; and back again to the present ordinary income treatment.

More recent experience demonstrates that favorable taxation rates do affect how retirees manage their retirement funds. So-called direct charitable rollover rules applied during the 2006 and 2007 tax years, allowing distributions up to $100,000 from retirement plans to be directed to certain charitable recipients. They were not subject to itemization or other limitations on charitable deductions, and they counted against the donor's minimum distribution. From all reports, use of the direct charitable rollover was gathering momentum and having a beneficial effect on charitable support before it lapsed in 2007.

If our experience with tax-favored distributions to charities is any indication, tax-favored distributions to the banks of the mortgage holders could be an odds-on winner.