A sophisticated financial cocktail is now being served by financial advisors that purports to dramatically save taxes for Americans with substantial wealth in their IRA who are facing the higher tax rates in the future we know are coming. The technique takes advantage of a loophole created by the Tax Increase Prevention and Reconciliation Act of 2005 ("TIPRA 2005") in which the the Modified Adjusted Gross Income ("MAGI") limits and filing status restrictions were abolished for Roth IRA conversions starting this year 2010. The cocktail blends this with an exploitation of fair market valuations in the context of assets with less liquidity, like, Limited Liability Companies AND, purportedly , cash flows acquired by structured settlement factoring transactions and could serve to ramp up individual investor interest in structured settlement factoring transactions and the acquisition of such cash flows in the secondary market.
Let's "belly up to the bar" and learn a little more about this potentially potent cocktail...
What is a Roth IRA?
A Roth IRA is a special type of retirement plan introduced by the Tax Payer Relief Act of 1997 (P.L. 105-34) whose "qualified distributions" are generally not taxed, provided certain conditions are met (most notable is a 5 year in Roth hold time). The Roth IRA's primary difference from most other tax advantaged retirement plans is that, rather than granting a tax break up-front when money is placed into the plan, the tax break is granted on the money withdrawn from the plan during retirement.
If someone wants to convert from a Traditional IRA to a Roth IRA they must pay taxes on the fair market value in the year of conversion. The question is how do you value your IRA assets at the time of the conversion? The income tax bill for a Roth conversion is based on the "fair market value" of the property that is moving from the traditional IRA to the Roth. The IRS definition of fair market value is "the price at which the asset would chnage hands between a willing buyer and willing seller, neither being under any compulsion to buy or sell, and both having reasonable knowledge of relevant facts". (see Treasury Regulation § 25.2512-1-6 Valuation of property; in general.)
Prior to August 2005, regular commercial annuity contracts were valued based on either their cash surrender value or current market value (if the sales charge surrender schedule had expired) This method of valuation gave annuity insurers an opportunity to artificially lower the value of their annuity contracts by assessing enormous surrender penalties to exploit the greatly reduced surrender value which would be taxed instead of the current value of the contract. The IRS eventually closed the loophole. Annuity contracts inside traditional IRAs are still valued according to their ash surrender value, but there are now limitations on how much less that amount can be than its fair market value.
The IRS issued final regulations on the valuation of annuity contracts in Roth conversions in July 2008. These regulations outline three methods that can be used to value annuity contracts for conversion purposes. They are listed as follows:
- Cost of Comparable Contract – This type of valuation can be used for contracts where the owner purchased the contract at an earlier date and will receive a payout on the contract at some point in the future. Then the contract is valued at the fair market value of a comparable current contract with the same future payout schedule, assuming that the annuity carrier offers a contract that matches those parameters.
If the conversion is made within a short period of time of the initial purchase, then the actual value of the current contract is used instead.
- Estimate of Reserves – If no comparable contract is available for the conversion in question. an interpolation is made of the contract’s terminal reserves, and the fair market value of the contract is then based upon this amount.
- Accumulation Method – Is used only for annuity contracts that have not annuitized. This method simply takes into the account the accumulated value of the contract, including any one-time sales charges or fees that were assessed over the prior year. Future distributions of any kind are disregarded under this method.
The "In Force Structured Settlement / Structured Settlement Factoring Gambit"
Some financial advisors are promoting a purported tremendous wealth preservation opportunity using a cocktail of in force structured settlements and Roth conversions and suggest that tremendous tax savings are to be had by employing the following steps:
1. Use the money in the traditional IRA to buy cash flows in the structured settlement secondary market. These are all acquired via a series of transactions that require Court approval.
2. The IRA holder then must have the acquired assets valued for purposes of the transfer to a Roth IRA. The standard is a fair market value , not a present value calculation, such as would be required in the event of premature death of payee for estate tax purposes.
3. Pay the taxes on the "fair market value", a substantial reduction from the cost of purchasing the assets.
4. Hold on for 5 years
How do we calculate the fair market value of a series of factored structured settlement cash flows? Are they valued like annuities or not? Some say in such cases that the IRA holder must get an appraisal which involves a survey of the open factoring market for structured settlement payment rights and getting a series of quotes. We all know from years of experience that the fair market will represent a substantial discount off the cost of the benefits. Think about the discount to cost that occurs when a "wet ink" factoring deal gets concluded. ostensibly we could be talking 30% less!
And to boot you can spread the tax over 2 years! IRC 408A(D)(3)(A)(iii) states:
"unless the taxpayer elects not to have this clause apply, any amount required to be included in gross income for any taxable year beginning in 2010 by reason of this paragraph (rollovers from eligible retirement plan other than Roth IRA) shall be so included ratably over the 2-taxable-year period beginning with the first taxable year beginning in 2011".
So in theory, can you spend $1,000,000 on structured settlement payments with your bloated IRA and magically turn it into a $700,000 value for tax purposes, toss it in a Roth and still keep the cash flows which are worth more than the FMV in terms of present value, wait 5 years and then "kick more ass" in retirement? Or is this another loop hole that will be closed?
Please note that if you avail yourself of any tax provisions that use Adjusted Gross Income ("AGI") as a baseline, income recognition as the result of the Roth IRA conversion process could affect any tax provisions that use AGI --e.g. including medical expenses (7.5% of AGI floor), miscellaneous deductions (2% of AGI floor), tax ability of Social Security (based on AGI), passive loss limitations (which based on AGI), and many others.
More on Roth IRAs
See IRC 408A
Footnote to the structured settlement industry primary market
We're not in Kansas anymore folks!