| Treasury Decision 9220 |
September 26, 2005 |
Converting an IRA Annuity to a Roth IRA
AGENCY: Internal Revenue Service (IRS), Treasury
ACTION: Temporary Regulations.
This document contains temporary regulations under section 408A of the
Internal Revenue Code (Code). These temporary regulations provide guidance
concerning the tax consequences of converting a non-Roth IRA annuity to a
Roth IRA. These temporary regulations affect individuals establishing Roth
IRAs, beneficiaries under Roth IRAs, and trustees, custodians and issuers
of Roth IRAs. The text of these temporary regulations also serves as the
text of proposed regulations (REG-122857-05) set forth in a notice of proposed
rulemaking in this issue of the Bulletin.
Effective Date: These regulations are effective
August 19, 2005.
Applicability Date: These regulations are applicable
to any Roth IRA conversion where an annuity contract is distributed or treated
as distributed from a traditional IRA on or after August 19, 2005.
FOR FURTHER INFORMATION CONTACT:
Concerning the regulations, Cathy A. Vohs, 202-622-6090.
SUPPLEMENTARY INFORMATION:
Roth IRAs and Conversions
This document contains temporary regulations that amend the Income Tax
Regulations (26 CFR part 1) under section 408A of the Code relating to Roth
IRAs. Section 408A of the Code, which was added by section 302 of the Taxpayer
Relief Act of 1997, Public Law 105-34 (111 Stat. 788), establishes the Roth
IRA as a type of individual retirement plan, effective for taxable years beginning
on or after January 1, 1998.
Under Code section 408A, a Roth IRA is treated like a traditional IRA
with several significant exceptions. Like amounts held in traditional IRAs,
amounts held in Roth IRAs generally are exempt from Federal income tax under
Code section 408(e)(1). Likewise, contributions to traditional IRAs and Roth
IRAs are subject to specific limitations.
The identifying characteristic of Roth IRAs is that all contributions
are after-tax contributions, and qualified distributions are tax free. Thus,
unlike certain contributions to traditional IRAs, which may be deductible,
contributions to Roth IRAs cannot be deducted from gross income. Distributions
from a traditional IRA are includable in gross income except to the extent
attributable to a return of basis. However, qualified distributions from
Roth IRAs are excludable from gross income. Under section 408A(d)(2), a qualified
distribution from a Roth IRA is a distribution that is made: (1) at least
5 years after the account owner (or the account owner’s spouse) made
a Roth IRA contribution, and (2) after age 591/2,
after death, on account of disability, or for a first-time home purchase.
A taxpayer whose modified adjusted gross income for a year does not
exceed $100,000 may convert an amount held in a non-Roth IRA (i.e.,
a traditional IRA or SIMPLE IRA) to an amount held in a Roth IRA. This conversion
requires taking into income the value of the non-Roth IRA being converted
(to the extent the conversion is not a conversion of basis in the non-Roth
IRA), essentially converting the value into an after-tax rollover contribution
to the Roth IRA. A conversion may be accomplished by means of a rollover,
trustee-to-trustee transfer, or account redesignation.
Regardless of the means used to convert, any amount converted from a
non-Roth IRA to a Roth IRA is treated as distributed from the non-Roth IRA
and rolled over to the Roth IRA. The conversion amount is generally includible
in gross income for the year of the conversion under section 408(d)(1) and
(2). In the case of a conversion involving property, the conversion amount
generally is the fair market value of the property on the date of distribution
or the date the property is treated as distributed from the traditional IRA.
Final regulations regarding Roth IRAs were published in the Federal Register on February 4, 1999 (T.D. 8816, 1999-1
C.B. 518 [64 FR 5597). Section 1.408A-4 provides rules relating to converting
amounts from a traditional IRA to a Roth IRA. Section 1.408A-4, A-7, which
sets forth the tax consequences of converting an amount held in a traditional
IRA to a Roth IRA, provides that any amount that is converted to a Roth IRA
is includible in gross income as a distribution according to the rules of
section 408(d)(1) and (2) for the taxable year in which the amount is distributed
or transferred from the traditional IRA.
Under A-1 of §1.408A-7, any amount converted from a non-Roth IRA
to a Roth IRA is treated as a distribution for which a Form 1099-R, “Distributions
From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance
Contracts, etc.” must be filed by the trustee maintaining
the non-Roth IRA.
Fair Market Value of Annuity Contracts
Before the enactment of section 408A, the need to value an annuity contract
as a result of distribution from a qualified plan or IRA rarely arose. The
distribution of an annuity contract from a qualified plan or a traditional
IRA is generally not a taxable event because, in most cases, the distributed
annuity account contract continues to be subject to requirements necessary
for tax deferral, e.g., the annuity remains subject to
the minimum distribution requirements of section 401(a)(9). In such a case,
no amount is includible in income until amounts are actually distributed from
the annuity contract. However, in certain situations, the Code provides that
the fair market value of an individual retirement annuity is treated as a
taxable distribution. For example, under section 408(e), the fair market
value of the annuity is included in taxable income if the annuity ceases to
be an individual retirement annuity because of violations of requirements
set forth under that subsection.
Section 25.2512-6 of the Gift Tax Regulations provides rules regarding
the valuation of certain life insurance contracts for gift tax purposes[3]. Under these rules, the value of a life insurance contract or
of a contract for the payment of an annuity issued by a company regularly
engaged in the selling of contracts of that character is established through
the sale of the particular contract by the company, or through the sale by
the company of comparable contracts. In addition, §25.2512-6 provides
that, as the value of an insurance policy through sale of comparable contracts
is not readily ascertainable when the gift is of a contract which has been
in force for some time and on which further premium payments are to be made,
the value may be approximated by adding to the interpolated terminal reserve
at the date of the gift the proportionate part of the gross premium last paid
before the date of the gift which covers the period extending beyond that
date. If, however, because of the unusual nature of the contract, such approximation
is not reasonably close to the full value, this method may not be used. Thus,
this method may not be used to determine the fair market value of an insurance
policy where the reserve does not reflect the value of all relevant features
of the policy. These gift tax valuation rules also apply for purposes of
commercial annuity contracts. See Examples 1 and 2 of
§25.2512-6. In addition, under §20.2031-8 of the Estate Tax Regulations,
the same rules govern the valuation of such life insurance and commercial
annuity contracts for estate tax purposes. See §§20.2031-7(b) and
20.2039-1(c).
Under A-12 of §1.401(a)(9)-6, an employee’s entire interest
under an annuity contract is the dollar amount credited to the employee or
beneficiary under the contract plus the actuarial value of any additional
benefits (such as survivor benefits in excess of the account balance) that
will be provided under the contract. This rule requiring that the value of
additional benefits under an annuity contract be included in the employee’s
entire interest, for purposes of determining the required minimum distribution
under section 401(a)(9), is based on the general requirement that the fair
market value of all assets must be reflected in valuing an account balance
under a defined contribution plan. However, certain additional benefits may
be disregarded for purposes of calculating the required minimum distribution,
such as when there is a pro-rata reduction in additional
benefits for a withdrawal and a guaranteed return of premiums upon death,
to reflect the fact that distributions are being made to satisfy section 401(a)(9).
Rev. Proc. 2005-25, 2005-17 I.R.B. 962, provides safe harbor formulas
that, if used to determine the value of a life insurance contact, retirement
income contract, endowment contract, or other contract providing life insurance
protection that is distributed or otherwise transferred from a qualified plan,
will meet the definition of fair market value for purposes of applying the
rules of section 402(a) (as well as sections 79, 83, and 402(b)).
Explanation of Provisions
These temporary regulations under section 408A clarify that, when a
non-Roth individual retirement annuity is converted to a Roth IRA, the amount
that is treated as distributed is the fair market value of the annuity contract
on the date the annuity contract is converted. Similarly, when a non-Roth
individual retirement account holds an annuity contract as an account asset
and the account is converted to a Roth IRA, the amount that is treated as
distributed with respect to the annuity contract is the fair market value
of the annuity contract on the date the annuity contract is distributed or
treated as distributed from the non-Roth IRA.
Some taxpayers and their advisers assert that the only amount includible
in income as a distribution when a non-Roth individual retirement annuity
is converted to a Roth IRA is the cash surrender value of the contract, even
when the cash surrender value does not accurately reflect the fair market
value of the contract. In particular, some advisers market a transaction
in which taxpayers are encouraged to invest their non-Roth IRA funds in a
single premium annuity contract with significant artificial penalties that
apply in the first year (or years) of the contract if the annuity is surrendered,
causing the annuity to have a low cash surrender value in the early years
of the contract. Under this transaction, shortly after the annuity contract
is purchased by the non-Roth IRA, the taxpayer converts the IRA to a Roth
IRA. In such a case, the taxpayer asserts that the only amount includible
in gross income as a result of the conversion is the low cash surrender value.
This assertion is made even though the surrender penalties are unlikely to
be paid because the taxpayers do not expect to surrender the contract during
the early years. In this case, the taxpayers expect that the ultimate payments
under the contract will be qualified distributions from the Roth IRA (i.e.,
tax-exempt), and thus, they also expect the artificially depressed cash surrender
value to be the only amount ever includible in gross income.
In another situation, a taxpayer purchases a non-Roth 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 a pro-rata reduction)
by the amount of the withdrawal. Prior to the date of conversion, the annuity
has a death benefit far in excess of the account value and the taxpayer withdraws
from the IRA annuity all but a minimum account value that will keep the IRA
annuity in force. Because the withdrawal reduces the guaranteed minimum death
benefit on a dollar-for-dollar basis, the remaining death benefit will be
significantly greater than the current account value, and accordingly, the
current account value will not reflect the fair market value of the contract.
For example, suppose such an individual retirement variable annuity has a
guaranteed minimum death benefit of $200,000 with an account value of $100,000.
The taxpayer withdraws $99,000 leaving a $1,000 account value and a $101,000
death benefit ($200,000 less $99,000). The taxpayer then converts the IRA
annuity into a Roth IRA and takes the position 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 $100,000 that will be paid upon the taxpayer’s
death. In this case, the taxpayer expects that the entire benefit payment
of $101,000 will be a qualified distribution from the Roth IRA (i.e.,
tax-exempt), and thus, expects that the $1,000 account value on the date of
conversion will be the only amount ever includible in gross income.
The IRS and Treasury Department have concluded that cash surrender value
is not always an appropriate measure of fair market value with respect to
non-Roth IRA annuities that are converted to Roth IRA annuities. Rather than
use the cash surrender value as the basis for determining fair market value,
these temporary regulations follow the gift tax regulations in providing that
the fair market value of an individual retirement annuity is established by
the premiums paid for such annuity if the conversion occurs soon after the
annuity was purchased.
Under the temporary regulations, 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. The temporary regulations further provide that,
if the conversion occurs after the annuity contract has been in force for
some time and future premium payments are to be made, fair market value is
determined through an approximation that is based on the interpolated terminal
reserve at the date of the conversion, plus the proportionate part of the
gross premium last paid before the date of the conversion which covers the
period extending beyond that date. However, if, because of the unusual nature
of the contract, this approximation is not reasonably close to the full value,
this method may not be used.
These temporary regulations also provide authority for the Commissioner
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 IRS and Treasury Department expect to issue additional guidance
regarding the rules to be used in determining the fair market value of a non-Roth
IRA annuity. It is anticipated that such guidance will be similar to the provisions
of Rev. Proc. 2005-25, 2005-17 I.R.B. 962 (April 25, 2005), except that the
adjustment for potential surrender charges, to the extent permitted, will
not exceed 9 percent. It is also anticipated that such guidance will provide
that in determining fair market value, the value of all additional benefits
(such as guaranteed minimum death benefits) under the contract must be taken
into account. The IRS and Treasury Department request comments regarding
this anticipated guidance. The IRS and Treasury Department also request comments
regarding whether the method used to calculate the fair market value of an
annuity contract that is converted to a Roth IRA should also apply for purposes
of the determining fair market value of an annuity contract under sections
408(e) and 401(a)(9). These comments may be submitted in conjunction with
the comments submitted on the proposed regulations discussed below.
Proposed regulations regarding the determination of fair market value
of an annuity contract are contained in this issue of the Bulletin. The preamble
and text of these temporary regulations also serves as the preamble and text
of the proposed regulations.
The temporary amendments to §1.408A-4 of the regulations are applicable
to any Roth IRA conversion where an annuity contract is distributed or treated
as distributed from a traditional IRA on or after August 19, 2005. No implication
is intended concerning whether or not a rule to be adopted in these regulations
is applicable law for taxable years ending before that date.
It has been determined that these temporary regulations are not a significant
regulatory action as defined in Executive Order 12866. Therefore, a regulatory
assessment is not required. It also has been determined that section 553(b)
of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to
these temporary regulations. For applicability of the Regulatory Flexibility
Act (5 U.S.C. chapter 6), refer to the notice of proposed rulemaking published
in this issue of the Bulletin. Pursuant to section 7805(f) of the Code, these
temporary regulations will be submitted to the Chief Counsel for Advocacy
of the Small Business Administration for comment on its impact on small business.
Adoption of Amendments to the Regulations
Accordingly, 26 CFR part 1 is amended as follows:
Paragraph 1. The authority citation for Part 1 continues to read, in
part, as follows:
Authority: 26 U.S.C. 7805 * * *
§1.408A-4T also issued under 26 U.S.C. 408A * * *
Par. 2. Section 1.408A-4 is amended by adding, in numerical order,
Q-14 and A-14, to read as follows:
§1.408A-4 Converting amounts to Roth IRAs.
* * * * *
Q-14. [Reserved]. For further guidance, see §1.408A-4T, Q-14.
A-14. [Reserved]. For further guidance, see §1.408A-4T, A-14.
Par. 3. Section 1.408A-4T is added to read as follows:
§1. 408A-4T Converting amounts to Roth IRAs.
* * * * *
Q-14. What is the amount that is includable in income as a distribution
when a conversion involves an annuity contract?
A-14. (a) In general. Notwithstanding §1.408-4(e),
when part or all of a traditional IRA that is an individual retirement annuity
described in section 408(b) is converted to a Roth IRA, for purposes of determining
the amount includible in gross income as a distribution under §1.408A-4,
A-7, the amount that is treated as distributed is the fair market value of
the annuity contract on the date the annuity contract is converted. Similarly,
when a traditional IRA that is an individual retirement account described
in section 408(a) holds an annuity contract as an account asset and the traditional
IRA is converted to a Roth IRA, for purposes of determining the amount includible
in gross income as a distribution under §1.408A-4, A-7, the amount that
is treated as distributed with respect to the annuity contract is the fair
market value of the annuity contract on the date that the annuity contract
is distributed or treated as distributed from the traditional IRA.
(b) Determination of fair market value—(1) General
rule. For purposes of this A-14, the fair market value of an individual
retirement annuity issued by a company regularly engaged in the selling of
contracts of that character generally is established as follows—
(A) If the conversion occurs soon after the contract was sold and there
have been no material changes in market conditions, the fair market value
of the contract is established through the sale of the particular contract
by the company (i.e., the actual premiums paid for such
contract);
(B) If the conversion occurs after the contract has been in force for
some time and no further premium payments are to be made, the fair market
value of the contract is established through the sale by the company of comparable
contracts;
(C) If the conversion occurs after the contract has been in force for
some time and future premium payments are to be made, the fair market value
of the contract is established through an approximation that is based on the
interpolated terminal reserve at the date of the conversion, plus the proportionate
part of the gross premium last paid before the date of the conversion which
covers the period extending beyond that date. However, if, because of the
unusual nature of the contract, this approximation is not reasonably close
to the full value, this method may not be used. Thus, this method may not
be used to determine the fair market value of an annuity contract where the
reserve does not reflect the value of all relevant features of the contract.
(2) Additional guidance. Additional guidance
regarding the fair market value of an individual retirement annuity, including
formulas to be used for determining fair market value, may be issued by the
Commissioner in revenue rulings, notices, or other guidance published in the
Internal Revenue Bulletin (See §601.601(d)(2)(ii)(b)).
(c) Effective date. The provisions of this A-14
are applicable to any conversion where an annuity contract is distributed
or treated as distributed from a traditional IRA on or after August 19, 2005.
(d) Definitions. The definitions set forth in
§1.408A-8 apply for purposes of this A-14.
Mark E. Matthews,
Deputy
Commissioner for
Services and Enforcement.
Approved August 9, 2005.
Eric Solomon,
Acting
Deputy Assistant Secretary for Tax Policy.
Note
(Filed by the Office of the Federal Register on August 19, 2005, 8:45
a.m., and published in the issue of the Federal Register for August 22, 2005,
70 F.R. 48868)
The principal author of these temporary regulations is Cathy A. Vohs
of the Office of the Division Counsel/Associate Chief Counsel (Tax Exempt
and Government Entities). However, other personnel from the IRS and Treasury
Department participated in the development of these regulations.
* * * * *
Internal Revenue Bulletin 2005-39
SEARCH:
You can either: Search all IRS Bulletin Documents issued since January 1996, or Search the entire site. For a more focused search, put your search word(s) in quotes.
2005 Document Types | 2005 Weekly IRBs
IRS Bulletins Main | Home
|
|
 |
