WASHINGTON - In a move that could quash one of the most controversial products in retail banking, the Internal Revenue Service proposed on Thursday to strip the Retirement CD of its tax-deferred status.
The product - a hybrid of a conventional CD and an annuity - has been touted as ideal for retirement planning and has been blessed by banking regulators. But the insurance industry has protested vigorously, calling the product a clear invasion of its turf.
The IRS plan, published in the April 6 Federal Register, eliminates the tax-deferred status for any bank-issued, annuity-like product with a maturity of more than one year. The proposal also strips the favorable tax treatment from any bank-issued product that allows consumers to withdraw most of their funds at once upon retirement.
The prototypical Retirement CD, created by American Deposit Corp., contains both of those options, just as many annuities do. But annuities underwritten by insurance companies - even those sold by banks - are not affected.
The IRS restrictions would make the Retirement CD significantly less attractive because consumers could no longer can use it as a long-range investment vehicle, tax lawyers said. Instead, the bank would have to begin paying out funds within one year to retain any tax benefits for the account.
"Under the proposed regulations the insurance company annuities will be far more attractive than those that are offered under the retirement certificate of deposit arrangements," said Tom Dwyer, a partner at Arnold & Porter.
"But, it is also fair to say that there are a lot of banks with a lot of interest in this, and they are not going to roll over and accept this without a fight," he added.
Insurance company representatives applauded the proposed rule. "We concur with the IRS's proposed regulation to tax bank-issued deferred annuities, including the Retirement CD, because we believe it reflects a clear and proper interpretation of current tax law," said Karen Addis, a spokeswoman for the American Council of Life Insurers. "We also believe this represents sound public policy."
Joseph Ignat, executive vice president of American Deposit, said the ruling "shocked" him. He said he plans to fight the IRS proposal, which the public can comment on in writing by July 18 or in person at an Aug. 8 hearing.
"It looks to us and our attorneys as if they are changing the law," Mr. Ignat said. "They are making up new law, a process reserved for Congress."
American Deposit is urging banks that offer the Retirement CD to change the product's terms to meet the IRS's proposed rules. He said customers would be allowed to revert to the current system if the IRS alters its proposal.
The IRS exempted anyone holding a deposit by today from the change, Mr. Ignat said.
"That, on its face, acknowledges that we are right," Mr. Ignat said. "If we were wrong, they would have rolled it back. So they are saying we are right, but we are changing the rules."
IRS official Jeffrey W. Maddrey, who helped write the rule, referred calls for comment to IRS public affairs, which in turn referred calls for comment to a Treasury department spokesman who was unavailable for comment.
Tax lawyers said the proposal was expected. "I didn't think it was a great surprise," said Willard Taylor, a partner at Sullivan & Cromwell. "Basically, it says annuities that are not issued by insurance companies are regular debt obligations."
That means they are taxable, just like a savings account deposit, he said.
The proposal makes the Retirement CD meaningless, he said. "What's the point of a one-year deposit," Mr. Taylor said. "I'm not sure who would want to get it."
Jim O'Connor, tax counsel at America's Community Bankers, said he has some problems with the proposal.
"It seems to me the IRS has made a policy decision in a regulation that is thin on analysis to say the Retirement CD is not entitled to the same tax treatment as annuities issued by insurance companies, despite the fact that they are functionally equivalent," Mr. O'Connor said. "That makes no sense from a policy point of view."
