Generally, when a traditional IRA is converted into a Roth IRA, the fair market value of the account is included in the individual's income, as if it were distributed. However, the absence of a specific rule addressing converted annuity contracts has led some taxpayers to believe that the amount includable in income upon conversion is the cash surrender value (i.e., that amount that would be available upon immediate surrender of the contract).

According to the IRS, this in turn has led to the development and promotion of specially-designed annuity contracts that are intended to suppress the amount of income which must be recognized upon conversion. These contracts provide for temporarily depressed cash surrender values that later "spring" up to a more realistic value. Under the rules applicable to Roth IRAs, the amounts received under those contracts will ultimately be tax-free, if they are paid after a 5-year holding period and attainment of age 59 ½.

The regulations specify that the full fair market value must be included in income upon conversion and provide standards for determining that fair market value. For example, if the conversion occurs soon after the contract was sold, the fair market value is generally its original purchase price.

These regulations, which will be effective for transfers made on or after August 19, 2005, will prevent taxpayers from using artificial devices to understate the value of the contract.