The Internal Revenue Service wants taxpayers to be reasonable when they are moving variable annuities into Roth individual retirement accounts.

The IRS has issued a temporary regulation forbidding taxpayers from cutting their taxes by using complicated strategies to reduce temporarily the stated value of annuities shifted into Roth IRAs.

The IRS also has notified taxpayers and their advisors that it will be developing a proposal to make the restrictions in annuity valuations permanent.

The permanent regulation probably will allow a 9% adjustment in VA valuations to reflect the cost of potential surrender charges. But the upcoming 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,” Cathy Vohs, an IRS official, writes in a preamble to the temporary regulations.

The U.S. Treasury Department, the parent of the IRS, has posted copies of the temporary and proposed regulations on the department Web site.

The regulations affect taxpayers who want to shift individual retirement annuities or variable annuities held within traditional individual retirement accounts into Roth IRAs.

Holders of Roth IRAs must pay federal income taxes before contributing income to the Roth IRAs. In return, the federal government will not tax Roth IRA retirement benefit payments.

When taxpayers move annuities from traditional IRAs to Roth IRAs, those taxpayers must include value of any annuities transferred in their taxable income.

In the past, many taxpayers have used VA cash surrender values as rough approximations of VA values.

These days, Vohs writes, the IRS is worried that taxpayers are trying to create huge gaps between VA cash surrender values and true VA fair market values.

Vohs gives the example of a taxpayer who sets up an individual retirement variable annuity with a $200,000 guaranteed minimum death benefit and 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],” Vohs writes. “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, Vohs writes, the taxpayer expects the IRS to treat the entire $101,000 benefit payment as a tax-exempt Roth IRA distribution and to include only the $1,000 account value in taxable income.

The IRS has decided to stop that kind of activity by using the VA valuation rules outlined in the gift tax regulations to guide valuations of annuities converted into Roth IRA assets, Vohs writes.

In most cases, Vohs writes, taxpayers can base fair market values on statistics for the sale of comparable annuity contracts, or on an estimate based partly on the amount of reserves in the contract at the time of the conversion.

But, “if, because of the unusual nature of the contract the approximation is not reasonably close to the full value, this method may not be used,” Vohs writes.

A copy of the temporary regulation is on the Web at http://www.treasury.gov/press/releases/reports/081905%20td9220.pdf.

The temporary regulation forbids taxpayers from cutting their taxes by using complicated strategies to reduce temporarily the stated value of annuities shifted into Roth IRAs