An individual taxpayer whose modified adjusted gross income for a year is not more than $100,000 may convert an amount held in a traditional IRA to a Roth IRA. The amount converted is subject to tax to the same extent that it would be if the amount were distributed to the taxpayer from the traditional IRA and not rolled over to another traditional IRA or to a qualified retirement plan.If a conversion involves property, the conversion amount generally is the fair market value of the property on the date of distribution, or deemed distribution, from the traditional IRA. However, because there was no specific rule dealing with converted annuity contracts, some taxpayers claimed that the amount includible in gross income upon the conversion of a traditional IRA to a Roth IRA is the cash surrender value of the annuity contract.
As a result, some companies developed and promoted specially designed annuity contracts that are intended to suppress the amount of income that must be recognized upon conversion. These contracts provide for temporarily depressed cash surrender values that later increase to a more realistic value.
Example 1: Your client invests the amount in his traditional IRA in a single premium annuity contract carrying significant artificial surrender penalties in the first years of the contract. This causes the annuity to have a low cash surrender value in the early years of the contract. Shortly after the annuity contract is bought, your client converts the traditional IRA to a Roth IRA, and claims that the only amount includible in gross income as a result of the conversion is the low cash surrender value.
This claim is made even though the surrender penalties are unlikely to be paid because your client does not expect to surrender the contract during its early years. Instead, she expects that, when made, the payments under the contract will be qualified distributions from the Roth IRA that are not includible in gross income, and that the artificially depressed cash surrender value will be the only amount ever includible in her gross income.
Example 2: Your client buys a traditional IRA individual retirement variable annuity with a guaranteed minimum death benefit equal to the highest account value ever attained under the contract, adjusted for withdrawals. If an amount is withdrawn from the contract, the death benefit is reduced dollar for dollar (rather than on a pro-rata basis) by the withdrawal amount.
Before the conversion date, the annuity has a death benefit far in excess of the account value, and your client withdraws from the IRA annuity all but a minimum account value necessary to keep it in force. Because the withdrawal reduces the guaranteed minimum death benefit on a dollar-for-dollar basis, the remaining death benefit is significantly greater than the current account value, and thus the current account value does not reflect the fair market value of the contract.
Thus, if your client's individual retirement variable annuity has a guaranteed minimum death benefit of $100,000 with an account value of $50,000, and he withdraws $49,000, that would leave a $1,000 account value and a $51,000 death benefit ($100,000 less $49,000). He then converts the IRA annuity into a Roth IRA, and claims that the $1,000 account value is the conversion amount, even though the account value does not reflect the fair market value of the additional $50,000 that will be paid when he dies. Here, your client expects that the entire benefit payment of $51,000 will be a qualified distribution from the Roth IRA that is not includible in gross income, and expects that the $1,000 account value on the date of conversion will be the only amount ever includible in his gross income.
The Internal Revenue Service has issued temporary regulations (Regulation § 1.408A-4T, Q&A 14) to show how to value annuity contracts held in a traditional IRA (or a traditional individual retirement annuity) that is converted to a Roth IRA. The regulations make it clear that fair market value, and not the cash surrender value, must be used to determine income recognized on the conversion. This is consistent with the rule of IRC § 408(e) that the fair market value of a traditional IRA annuity is included in gross income if it ceases to be an individual retirement annuity because the IRA rules have been violated.
Fair value on conversion
When it comes to determining an annuity's fair market value when a traditional IRA is converted to a Roth IRA, instead of using the cash surrender value as the basis for determining the fair market value of an annuity, the temporary regulations follow the rules contained in gift tax regulations. Thus, fair market value is established as follows:
* If the conversion occurs soon after the contract was sold and there have been no material changes in market conditions, the fair market value is established through the sale of the particular contract by the company (i.e., the actual premiums paid for the contract).
* If the conversion occurs after the annuity contract has been in force for some time and no further premium payments are to be made, fair market value is determined through the sale by the company of comparable contracts.
* If the conversion occurs after the annuity contract has already been in force and future premium payments are to be made, fair market value is determined through an approximation based on the interpolated terminal reserve on the conversion date, plus the proportionate part of the gross premium last paid before the date of conversion that covers the period extending beyond that date. However, this method can't be used if, because of the unusual nature of the contract, this approximation is not reasonably close to the full value.
The temporary regulations also provide authority for the IRS to issue additional guidance regarding the fair market value of an individual retirement annuity, including formulas to be used for determining fair market value. The service expects that this guidance will be similar to the provisions of Rev. Proc. 2005-25, 2005 17-IRB, which deals with the value of life insurance contracts, retirement income contracts, endowment contracts or other contracts providing life insurance distributed from qualified plans.
However, the adjustment for potential surrender charges, to the extent permitted, won't exceed 9 percent. And in determining the fair market value, the value of all additional benefits (such as guaranteed minimum death benefits) under the contract will have to be taken into account.
Effective dates
The temporary regulations apply to any Roth IRA conversion where an annuity contract is distributed or treated as distributed from a traditional IRA on or after Aug. 19, 2005. The service intends no implication as to whether or not the rules adopted in the regulations apply to taxable years ending before that date.
