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.

Legislative History
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.

Conclusion
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.

Related Articles
  1. Retirement

    The World's Most Luxurious Retirement Destinations

    If money is no object (or if you would just like to dream), these five spots are the crème de la crème.
  2. Professionals

    Your 401(k): How to Handle Market Volatility

    An in-depth look at how manage to 401(k) assets during times of market volatility.
  3. Professionals

    How to Build a Financial Plan for Gen X, Y Clients

    Retirement is creeping closer for clients in their 30s and 40s. It's a great segment for financial advisors to tap to build long-term client relationships.
  4. Professionals

    Don't Let Your Portfolio Be Trump'd by Illiquidity

    A look at Donald Trump's statement of finances and the biggest lesson every investor can learn.
  5. Professionals

    What to do During a Market Correction

    The market has corrected...now what? Here's what you should consider rather than panicking.
  6. Retirement

    Maxing Out Your 401(k) Is Profitable: Here's Why

    It's shocking, but most American workers (73%) have no 401(k) retirement funds. Start saving now to anchor your retirement.
  7. Retirement

    How to Choose the Best Long-Term Care Insurance

    Here's how to find and select a policy that provides the best coverage for you.
  8. Retirement

    How to Choose the Best Medicare Advantage Plan

    Medicare Advantage offers an alternative to Medicare and Medigap. Here’s what you need to know to choose the best plan.
  9. Professionals

    What Kind of Insurance Do RIAs Need?

    Advisors spend a lot of time discussing insurance with clients but they also need to consider their own coverage needs as small-business owners
  10. Professionals

    Top Questions to Ask When Choosing a Robo-Advisor

    Think a robo-advisor might be the right choice for you? Be sure to ask these questions first.
RELATED TERMS
  1. Qualified Longevity Annuity Contract

    A Qualified Longevity Annuity Contract (QLAC) is a deferred annuity ...
  2. Wealth Management

    A high-level professional service that combines financial/investment ...
  3. See-Through Trust

    A trust that is treated as the beneficiary of an individual retirement ...
  4. Backdoor Roth IRA

    A method that taxpayers can use to place retirement savings in ...
  5. Current Service Benefit

    The amount of pension benefit accrued by an employee who had ...
  6. Contingent Annuitant

    Someone designated by an annuitant to receive the annuitant’s ...
RELATED FAQS
  1. Can a variable annuity be rolled into an IRA?

    You can roll qualified variable annuities, such as other qualified retirement plan accounts, into a traditional IRA. Non-qualified ... Read Full Answer >>
  2. What are the best ways to sell an annuity?

    The best ways to sell an annuity are to locate buyers from insurance agents or companies that specialize in connecting buyers ... Read Full Answer >>
  3. How are non-qualified variable annuities taxed?

    Non-qualified variable annuities are tax-deferred investment vehicles with a unique tax structure. After-tax money is deposited ... Read Full Answer >>
  4. Can you buy penny stocks in an IRA?

    It is possible to trade penny stocks through an individual retirement accounts, or IRA. However, penny stocks are generally ... Read Full Answer >>
  5. Can I use my IRA to pay for my college loans?

    If you are older than 59.5 and have been contributing to your IRA for more than five years, you may withdraw funds to pay ... Read Full Answer >>
  6. Can my IRA be used for college tuition?

    You can use your IRA to pay for college tuition even before you reach retirement age. In fact, your retirement savings can ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!