Reviewed or updated February 8, 2018
An August 2005 regulation addresses the use of annuities in converting a traditional IRA to a Roth.
Some people just won’t behave. One example comes from scam artists promoting the idea that you can vastly reduce the tax cost of converting a traditional IRA to a Roth IRA if you invest in an annuity before the conversion. An August 2005 regulation puts an end to this abuse.
When you convert a traditional IRA to a Roth, you have to report taxable income equal to the value of all the investments in the traditional IRA. You don’t use the original purchase price of the investment if the actual value at the time of the conversion is higher or lower. Someone came up with the idea of claiming that the value of an annuity is equal to its cash surrender value. Immediately after you buy an annuity, the cash surrender value is less than the amount paid for it, so this approach would result in a smaller amount of taxable income when you convert the IRA.
To enhance this tax benefit, some promoters used annuities that had artificially low cash surrender value for a period of time after the purchase date. The intended result was an artificially low tax bill for the conversion. The annuity would recover more value as time passed, so the owner of the IRA didn’t really give up any value by accepting a low cash surrender value for a period of time.
The approach is abusive because the law requires you to report the full fair market value of the assets in your IRA at the time of the conversion, and the cash surrender value of an annuity does not reflect its full fair market value. This is obvious when the cash surrender value immediately after a purchase is significantly lower than the amount paid to buy the annuity, because no one would voluntarily pay more for an investment than its true value.
In August 2005 the Treasury issued a regulation designed to put an end to this abuse. It says that in a conversion occurring soon after the purchase of an annuity, the value of the annuity is established by the premiums used to purchase the annuity rather than its cash surrender value. The regulation also requires genuine valuation, rather than use of cash surrender value, for annuities that have been in force for a period of time. Details can be found in Q&A 14 of the final version of the regulation reproduced here.