Converting an IRA Annuity to a Roth IRA

Overview

  • On July 29, 2008, the IRS and the Treasury Department issued final regulations regarding income tax consequences of Roth IRA conversions.
  • These regulations apply where an annuity contract is converted from a non-Roth IRA (i.e., traditional, SEP, or SIMPLE) on or after August 19, 2005.

If an annuity contract is converted to a Roth IRA, the fair market value of the contract — the amount that is treated as a taxable distribution — may be more than the cash surrender value of the annuity contract.


Two situations of abuse that the regulations address:

Situation One

The taxpayer invests a traditional IRA in an annuity. Almost immediately, the taxpayer then converts the contract to a Roth IRA, and claims only the cash surrender value was includable in income for conversion purposes, excluding the value of the contract to surrender penalties.
 

Situation Two

The taxpayer invests a traditional IRA in an annuity and takes withdrawals from the contract that reduce the value of the death benefit on a dollar-for-dollar basis until the contract value is at the minimum required to keep the contract in force. This results in the death benefit being greater than the contract value. Then, the taxpayer converts the contract to a Roth IRA and claims only the minimum contract value is includable as income for conversion purposes and excludes the value of the death benefit.

 
The regulations provide that the cash surrender value will not always be an appropriate measure of the fair market value for conversion purposes.

For example:

An owner has an IRA (invested in a variable annuity) with a dollar-for-dollar withdrawal provision that has a guaranteed minimum death benefit of $200,000 and an account value of $100,000. If the taxpayer transfers $99,000 to another IRA and then converts the $1,000 of remaining contract value to a Roth IRA, under the final regulations, the fair market value for tax purposes would be adjusted for the $101,000 remaining death benefit, not the $1,000 of remaining contract value.

 

These regulations do not apply to:

  • IRA assets invested in the past in an annuity that has been fully surrendered without any remaining optional or death benefits.
  • Existing Roth IRAs invested in annuity products. 

Taxable income from the conversion is included in gross income and reported on Form 1099-R for the year in which the conversion occurs. The additional 10% federal tax does not apply to the conversion amount.

It’s important to know that there may be differences in interpretation of the regulations and the actual calculation of values among financial institutions. If your client is considering converting a traditional IRA to a Roth IRA, help him or her contact the financial institution to learn about the tax consequences of the transaction.


Calculator: Should I Convert to a Roth IRA?

Use this calculator to help determine whether or not to convert to a Roth IRA.

Additional Resources

 

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This material is not intended to be used, nor can it be used by any taxpayer, for the purpose of avoiding U.S. federal, state, or local tax penalties. This material is written to support the promotion or marketing of the transaction(s) or matter(s) addressed by this material. Pacific Life, its affiliates, their distributors, and respective representatives do not provide tax, accounting, or legal advice. Any taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax advisor or attorney. 

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