[Federal Register Volume 70, Number 161 (Monday, August 22, 2005)]
[Rules and Regulations]
[Pages 48868-48871]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 05-16403]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9220]
RIN 1545-BE66


Converting an IRA Annuity to a Roth IRA

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Temporary Regulations.

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SUMMARY: 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 
set forth in a notice of proposed rulemaking in the Proposed Rules 
section of this issue of the Federal Register.

DATES: 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, 202-622-6060.

SUPPLEMENTARY INFORMATION:

Background

Roth IRAs and Conversions

    This document contains temporary regulations that amend the Income 
Tax Regulations (26 CFR part 1) under section 408A of 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

[[Page 48869]]

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 includible 
in gross income except to the extent attributable to a return of basis. 
However, qualified distributions from Roth IRAs are excludible 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 59\1/2\, 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 (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 Sec.  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, IRA, Insurance Contracts,'' 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.\1\ 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, Sec.  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 Sec.  25.2512-6. 
In addition, under Sec.  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 Sec. Sec.  20.2031-7(b) 
and 20.2039-1(c).
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    \1\ In Rev. Rul. 59-195 (1959--1 C.B. 18), the IRS ruled that, 
in situations similar to those in which an employer purchases and 
pays the premiums on an insurance policy on the life of one of its 
employees and subsequently sells such policy, on which further 
premiums must be paid, the value of such policy for computing 
taxable gain in the year of purchase should be determined under the 
method of valuation prescribed in Sec.  25.2512-6 of the Gift Tax 
Regulations.
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    Under A-12 of Sec.  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 
contract, 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

[[Page 48870]]

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 the Proposed Rules 
section of the Federal Register. The preamble and text of these 
temporary regulations also serves as the preamble and text of the 
proposed regulations.

Effective Date

    The temporary amendments to Sec.  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.

Special Analyses

    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 the Proposed 
Rules section

[[Page 48871]]

of this issue of the Federal Register. 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.

Drafting Information

    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.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

0
Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for Part 1 continues to read, in 
part, as follows:

    Authority: 26 U.S.C. 7805 * * *
    Sec.  1.408A-4T also issued under 26 U.S.C. 408A * * *


0
Par. 2. Section 1.408A-4 is amended by adding, in numerical order, Q-14 
and A-14, to read as follows:


Sec.  1.408A-4  Converting amounts to Roth IRAs.

* * * * *
    Q-14. [Reserved]. For further guidance, see Sec.  1.408A-4T, Q-14.
    A-14. [Reserved]. For further guidance, see Sec.  1.408A-4T, A-14.

0
Par. 3. Section 1.408A-4T is added to read as follows:


Sec.  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 Sec.  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 Sec.  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 Sec.  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 Sec.  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 Sec.  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.
[FR Doc. 05-16403 Filed 8-19-05; 8:45 am]
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