One of the most interesting things about the US banking system is just how decentralized it is. While most developed nations have just a handful of major banks, the United States pairs those nationwide behemoths with thousands of smaller banks and credit unions that may serve an area as small as a single city or county.
Of course, in the 21st century these small banks are hardly a “secret,” since any bank with a website has long ago been sucked into the search engine maw, but I still find the best way to learn about them is by keeping my eyes open while I’m traveling. That’s precisely how I first found out about the Willamette Valley Bank’s “First Time Home Buyer Savings Account.”
What fresh hell, I asked myself, was this?
While not exactly common, there are a handful of states that offer these accounts, and the details vary enormously, which makes it a good opportunity to think through how to approach these gimmicks periodically spun up by legislators trying to encourage one supposedly virtuous behavior or another.
Federal or state tax benefits?
This is the most important question to ask, since state income tax rates are dramatically lower than federal income tax rates. For example, contributions to traditional IRA’s and 401(k)’s are untaxed at the federal level, and since most states use your federal income (plus and minus any state adjustments) to calculate your state income tax liability, federal income tax deductions — when available — are several times more valuable than state-only income tax deductions.
Since the American people are a hateful people, eligibility for tax-advantaged accounts frequently hinges on your current-year or prior-year income. Since your income tax rate also depends on your income, tax-advantaged accounts are often unavailable to the people who would benefit most from them, and are of little value to the people eligible for them. This keeps their budgetary cost low, their benefits negligible, and the tax code unnecessarily complex.
I sometimes come across what seems like an unbelievable opportunity and only upon further research discover that the maximum annual contribution is just one or two hundred dollars. When one of those accounts comes across your desk there’s no need to dismiss it out of hand, just acknowledge that it will always be ornamental, not foundational, to your personal finances.
Deductible contributions or earnings
Deductible contributions are most valuable in the year the contribution is made, and allow you to time your contributions for years where your marginal tax rate is especially high. Deductible earnings (like the tax-free withdrawal of earnings from Roth retirement accounts) are more valuable if you expect either your income or income tax rates in general to rise in the future.
Investment options and interest rates
In employer-based plans like 401(k)’s and 403(b)’s your investment options are almost always determined by your employer with little or no say from employees (until they sue). State-based 529 plans hire their own administrators that may offer more or less discretion to investors. And IRA’s offer the maximum choice in investment options since you can open as many as you want and move between them relatively freely.
Meanwhile, the gimmick accounts administered by banks offer interest rates on a “take it or leave it” basis. In today’s interest rate environment I usually prefer to leave it than take it, but opportunities occasionally come up for out-sized earnings on deposit accounts, even if they’re (horror of horrors!) taxable.
Deadlines and penalties on withdrawals
I’ve written before about the weird interest rate structure of Series EE bonds, which offer 3.53% APY exempt from state income taxes, but only if the proceeds are used in the year of redemption on eligible higher education expenses. Almost all gimmick accounts have restrictions like this: HSA accounts for health care expenditures, retirement accounts for old age, 529 accounts for almost anything education related these days, and first-time home buyer savings accounts for the purchase of homes by first-time buyers. If you don’t meet the requirements of any given gimmick account, you usually have to pay back some or all of the tax benefits you claimed along the way, and often a penalty on any earnings in the account.
How do first-time home buyer savings accounts stack up?
With these basic metrics in mind, how do Oregon first-time home buyer savings accounts stack up?
- State tax benefits. For single filers, up to $5,000 in contributions and earnings can be deducted (note that Oregon calls them “subtractions” instead of deductions) from your Oregon taxable income for up to 10 years. Married filing jointly filers can deduct up to $10,000. Regardless of your filing status, the maximum total deduction is $50,000 over 10 years, so joint filers can maximize the tax benefits over just 5 years instead of 10.
- Income limitations. The deduction begins to phase out when your federal adjusted gross income reaches $104,000 for single and head of household filers and $149,000 for married filing jointly filers (see page 69 of this publication). At those income levels your marginal Oregon income tax rate is 8.75%, giving a maximum annual benefit of $437.50 or $875 on contributions and earnings of $5,000 or $10,000 per year (if your marginal tax rate is lower your maximum benefit is correspondingly lower).
- Contribution limits. While the state income tax deduction is limited to $5,000 or $10,000 in contributions and earnings per year, there’s no limit on the total contributions you can make. Since these accounts are designed to be held for several years without withdrawals, banks and credit unions may offer more competitive interest rates on them. Rates are currently low everywhere, but the 2% APY offered by Willamette Valley Bank works out to an after-tax equivalent of about 2.2% APY: nothing to write home about, but almost double the rate available today on 10-year Treasury notes.
- Deductible contributions and earnings. When used for their intended purposes, neither your contributions nor your earnings are ever taxed at the state level (up to the $5,000/$10,000/$50,000 limits).
- Interest rates. The interest rates earned on these accounts are set by the banks and credit unions offering them, and are variable, so you shouldn’t count on keeping the interest rate on offer when you opened your account. On the flip side, they can’t go much lower, so if interest rates do rise in the future that might eventually be reflected in bank rates as well. While you can only have one of these accounts open in Oregon at a time, you can move the money between banks relatively easily if you want to chase higher rates as they fluctuate.
- Deadlines. There are two numbers to keep in mind: 3 years and 10 years. To open an account, you have to be “planning” to purchase a home in Oregon within the next 10 years, and you cannot have owned or purchased a home in the 3 years prior to your planned purchase. If you look at these statements closely, you can see that you may be eligible to open a first-time home buyer savings account even if you already own a home, as long as you “plan” to no longer own one at least 3 years prior to your “planned” home purchase.
- Penalties. If you make any withdrawals from the account for anything but qualifying home buying expenses within the first 10 years of opening the account, you’ll owe a penalty of 5% of the withdrawn amount, and add the amount of the withdrawal to your Oregon state tax return in the year of the withdrawal. After 10 years, the 5% penalty is not imposed, but the entire amount of your deductions over the lifespan of the account is added back to your Oregon taxable income. I was unable to easily find any information about how to calculate the amount to add back in the event of non-deductible contributions and earnings (those above the $5,000/$10,000/$50,000 limits), but I assume it would be on a proportional basis (I’m not an accountant, and I’m definitely not your accountant, so ask him or her instead).
An interest-free loan from the good people of Oregon
The absolute most essential thing to understanding all types of gimmick accounts is that they are never designed to achieve their supposed purpose. IRA’s aren’t for retirement security, 529 plans aren’t for college affordability, and first-time home buyer savings accounts aren’t for housing access. Each and every one is designed to help rich people shield their income and assets from taxation, and in this, they are phenomenally successful.
The scam, in this case, is especially obvious, and works well for a married couple with variable income. That’s because they have 10 years to reach the maximum $50,000 deduction (worth up to $4,375 in tax savings). In years where their marginal income tax rate is lower, they can skip contributions altogether and deduct only the earnings on the account, and in high-income years they can make the contribution that will maximize the deduction (after accounting for earnings). After 10 years, the $50,000 they previously subtracted is added to their Oregon state taxable income. If for the sake of simplicity you assume that $50,000 is the entirety of their Oregon state income that year, then they’ll owe just $4,122 in taxes on it; they’ve literally borrowed money from the state at a negative interest rate! Of course, even if they pay the entire $4,375 back in taxes, they’ll be repaying the 0% loan with less valuable future-dollars, and will have enjoyed the use of the money for 1-10 years.
It’s not good that these accounts exist, and I would greatly prefer they did not. But if the people of Oregon want to make 0% loans to wealthy people in order to help them manage their income taxes, as long as you qualify you’d be crazy not to take advantage.
Now that I’ve provided this detailed framework, in a future post I’ll be able to provide a (much briefer!) overview of the similar accounts offered by other states.