2010 has been hailed as the year for Roth conversions. Many taxpayers with higher incomes are now able to convert large IRA or qualified plan balances into Roth accounts in a single year without regard to the income threshold limitation that previously applied. And in many cases, the IRA or other tax-deferred plan is housed inside a fixed, indexed or variable annuity contract. Those who convert annuities housed inside IRAs should know that special valuation rules apply to all Roth IRA conversions in addition to the standard set of conversion rules. This article examines the past and current legislation that governs IRA annuity conversions.
Before August of 2005, annuity contracts were valued according to either their cash surrender value or current market value, if the back-end sales charge surrender schedule had expired. This method of valuation provided annuity carriers with the opportunity to try and artificially lower the value of their annuity contracts by assessing enormous surrender penalties in the first year or two of the contract. The owner would then convert the contract during this period so that the greatly reduced surrender value would be taxed instead of the current value of the contract. For example, a carrier would levy a 20% surrender charge on a contract during the first year. IRA owners would then purchase the annuity inside their IRAs and convert them to Roth IRAs. An owner who purchased a $50,000 contract would only have to pay taxes on $40,000 after the 20% surrender penalty was deducted. But the IRS eventually closed this loophole, issuing a temporary ruling against this practice that was eventually finalized. Annuity contracts inside traditional IRAs are still valued according to their cash surrender value, but there are now limitations on how much less that amount can be than its fair market value.
Current Valuation Rules
The IRS issued final regulations on the valuation of annuity contracts in Roth conversions in July of 2008. These regulations outline three separate methods that can be used to value annuity contracts for conversion purposes. They are listed as follows:
- Cost of Comparable Contract – This type of valuation can be used for contracts where the owner purchased the contract at an earlier date and will receive a payout on the contract at some point in the future. Then the contract is valued at the fair market value of a comparable current contract with the same future payout schedule, assuming that the annuity carrier offers a contract that matches those parameters.
For example, assume that a taxpayer purchases an annuity at age 50 and converts it to a Roth IRA at age 60. The contract is scheduled to pay the owner $1,000 per month beginning at age 65. The value of the contract at the time of conversion will be considered equal to the fair market value of a new contract from the annuity carrier that pays the same amount at age 70 that is purchased by a 60-year old. If the conversion is made within a short period of time of the initial purchase, then the actual value of the current contract is used instead.
- Estimate of Reserves – This method is used if no comparable contract is available for the conversion in question. When this is the case, an interpolation is made of the contract's terminal reserves, and the fair market value of the contract is then based upon this amount.
- Accumulation Method – This method is the simplest of the three methods, and is used only for annuity contracts that have not annuitized. This method simply takes into the account the accumulated value of the contract, including any one-time sales charges or fees that were assessed over the prior year. Future distributions of any kind are disregarded under this method.
Guaranteed Benefit Riders
Owners of variable annuities with guaranteed living benefit riders may be in for a surprise when they convert their contracts to Roth IRAs. The net present value of the payout from an income rider is usually added to the value of the contract. The exact amount that is factored in is actuarially determined by the annuity carrier and will vary somewhat from one company to another as there are several methods of doing this. But it cannot be computed by the owner.
Owners of variable contracts with guaranteed riders of any kind should therefore expect the assessed value of their contracts to exceed the fair market value if the value of the contract has declined due to adverse market conditions. (Learn more about riders in Living and Death Riders: How Do They Work?)
Reporting and Recharacterization
Regardless of the valuation method used, annuity owners can always rely on Form 1099-R to report the correct amount for their Roth conversions. In most cases, this form will reflect one of the valuation methods described previously. But those who are unpleasantly surprised by the amount reported on their tax form have the option to recharacterize their conversions before October 15 of the following year.
Annuity owners who convert their traditional IRA contracts to Roth IRAs should be prepared to see a somewhat different amount on their tax form than the current market value of their contract in many cases. If you have any questions about the amount shown on your Form 1099-R, contact your annuity carrier or consult your tax or financial advisor.
For related reading, take a look at The Simple Tax Math Of Roth Conversions.