Roth Conversion of an IRA containing an annuity
I have a question regarding the Roth Conversion in 2010. A client has come to us with an existing annuity inside a traditional IRA. The account value is 100K and the living benefit (income base) value is 200K. We want to convert to a ROTH IRA in 2010 for lifetime tax free income. How is the tax calculated? I assume the IRS will look at their life expectancy and tax them on the present value of the income payments and not the 100K account value, correct?
Permalink Submitted by Alan Spross on Mon, 2009-03-09 18:33
You are correct. The insurance company will have to quote the valuation they must use under TD 9418 attached, and that is the figure that will show on the 1099R. Of course, the client can report the income @ 50% in 2011 and 2012 for 2010 conversions. I think it would be a good idea for the client to request that the calculation be double checked for accuracy. If he has second thoughts, the recharacterization option is always available as late as 10/15/2011 and he should have a fairly good idea of his expected tax bill for 2011 at that point.
http://www.natptax.com/td9418.pdf
Permalink Submitted by Joseph Arsenault on Tue, 2009-03-10 20:31
I think this really comes down to what the insurance company considers the fair market value..The reg says, “the amount that is treated as distributed is the fair market value of the annuity contract on the date the annuity contract is converted.” Its hard to say that the income value is the fair market value when its phantom number, and in no way the tangible account value. If the income value has not be triggered there is no guarantee it will be used, so how does the IRS assume to use the life expectancy and present value of the payments? It would seem that the FMV would be the amount distributed if the annuity was surrendered on that date.
Alan maybe you noticed something else that defines FMV for this purpose? Very interesting question to say the least. Thanks
Permalink Submitted by Alan Spross on Tue, 2009-03-10 22:52
A more precise response to the original post is dependent on the specific type of living benefit involved here (GMWB, GMIB, etc etc). However, the IRS methods approved for determining the conversion value do NOT include some of the factors that do not count in determining an RMD value, such as most death benefits. Therefore, the conversion value in many cases will be HIGHER than the corresponding FMV for RMD purposes. The IRS adopted these provisions in 2005 and thereafter to shut down various Roth conversion schemes based on depressing the value of an annuity for conversion tax purposes, while passing through many of the benefits to the Roth IRA. Most of these Roth conversion schemes involved pre conversion distributions that did not reduce the value of the annuity fringe benefits in proportion (dollar for dollar vrs proportional reductions). In a depressed stock market such as we have now, the cash values are highly depressed vrs the fringe benefits. Reinsurers of these benefits are getting killed just like they did 7 years ago in the last bear market, so the costs of these benefits will be sharply increased in the future.
The calculation is very complex and therefore mostly dependent on the insurance company’s software to calculate the present values of the various combinations of fringe benefits. Of course, you should be able to get a quote on the taxable amount, but it’s not easy to check that quote for accuracy. The higher the various fringe benefit calculation bases grow in excess of the current cash surrender value, the higher the Roth conversion FMV value becomes.
Permalink Submitted by Joseph Arsenault on Tue, 2009-03-10 22:58
Alan, very thorough response and well articulated. Makes sense.