Final Regulations Clarify the Tax Treatment of Payments by Qualified Retirement Plans for Accident or Health Insurance and Provide New Rules for Plans Purchasing Disability Insurance
The Internal Revenue Service (“IRS”) recently issued final regulations clarifying the rules regarding the tax treatment of premium payments by qualified retirement plans (including pension, profit sharing and 401(k) plans) for accident or health insurance covering a plan participant (or a beneficiary or alternate payee under a qualified domestic relations order), where the premium payments are charged against such individual’s plan benefit.
In addition, the guidance articulates a new rule governing the tax treatment of insurance premiums paid by a defined contribution plan (such as a profit sharing or 401(k) plan) and charged against an employee’s plan account for disability insurance, where the payments under the insurance policy in the event of disability replace the contributions that otherwise would have been made to the plan absent the participant’s disability. Even with the guidance, however, there still remain a number of unanswered questions.
Tax Treatment of Accidental or Health Insurance Premiums
The final regulations clarify that premiums paid by a qualified plan for accident or health insurance (including qualified long-term care insurance) are taxable distributions to the participant in the year in which the premiums are paid, unless a statutory exception applies. (The statutory exceptions preventing immediate taxation include (i) premium payments paid on behalf of qualified public safety officers and (ii) premium payments by a qualified retiree health account under the Internal Revenue Code).
Because charging the insurance premium against the employee’s account is treated as a taxable distribution from the plan to the employee, the premiums are considered to be paid by the employee and not by the employer (or the plan). As a result, the amounts received under the accident or health insurance plan are treated as neither paid by the employer nor attributable to contributions by the employer that are excludable from the employee’s gross income. Accordingly, the benefits or reimbursements for personal injuries or sickness received through the accident or health insurance plan whose premiums are paid by a qualified plan are generally excludable from the employee’s gross income. However, to the extent that the employee took deductions for the premium distribution from his or her gross income when the premiums were paid, the benefits or reimbursements received through the accident or health insurance plan would be includable in gross income. The transaction is essentially the same as the employee purchasing the insurance policy with after tax dollars. Similarly, such benefits or reimbursements are not treated as distributions from the plan.
Separate from the guidance provided under these final regulations, other tax-qualification rules may limit or restrict an employee’s ability to receive a distribution from a qualified retirement plan while still employed (or may only apply if the employee is under a specified age). (One such provision permits an employee who is under age 59 1/2 to receive an in-service distribution from his or her 401(k) account only in the event of a financial hardship.) A failure to comply with such distribution rules can endanger the plan’s tax-qualified status. Accordingly, because charging a premium payment against an employee’s benefit will be treated as a distribution from the plan, care should be given before any decision is made to do so.
Tax Treatment of Disability Insurance Premiums
Premiums paid from an employee’s account in a defined contribution plan for disability insurance are not treated as distributions from the plan to the employee, provided the following requirements are met:
- the insurance policy provides for the payment of benefits to the plan only if the employee is unable to continue in employment due to disability,
- the payments under the insurance policy in the event that the employee in fact becomes disabled are credited to the employee’s plan account, and
- the amount paid under the insurance policy for each year does not exceed “the reasonable expectation of the annual contributions that would have been made to the plan on the employee’s behalf for the period of disability within that year, reduced by any other contributions made on the employee’s behalf for the period of disability within that year.”
Based upon the preamble to the regulations, the “reasonably expected future salary increases” that the employee would otherwise have received during the period of the disability may be taken into account in determining the “reasonable expectation” of the amount of the contribution that would otherwise have been made.
An example provided in the final regulations, under which disability insurance was provided only for participants who elected to be covered under the insurance contract, makes clear that the disability insurance policy can make up for (i) any pre-tax contributions that an employee would otherwise have made during the period of the disability, (ii) any related employer-paid matching contributions the employee would have received, and (iii) any employer-paid non-elective (or profit sharing) contributions.
If the three-prong test above is met, the insurance contract will also be treated as a plan investment, and the payments received under the contract and credited to the employee’s plan account will in turn be treated as a return on that investment (and not as a contribution to the plan). In addition to not being subject to the rules that govern plan contributions, this also means that the amounts paid under the insurance contract and credited to the employee’s account will not be taxable to the employee at that time. Instead, the regular rules governing the taxation of plan distributions will apply (under which amounts are taxed when they are distributed from the plan, unless timely rolled over to an individual retirement account, or annuity, or to another qualified plan.)
Although the final regulations provide guidance on the types of plan contributions that an insurance policy can make up for in the event of a participant’s disability, they leave a number of unanswered questions, including what definition of “disability” is used for this purpose. The final regulations also do not provide any guidance as to how to determine the amount of any pre-tax contributions that the employee would have otherwise elected to make had he or she not become disabled.
Finally, although not addressed in these regulations, characterizing a disability insurance policy which meets the above requirements as a plan investment would appear to implicate the fiduciary provisions of Title I of the Employee Retirement Income Security Act. (These fiduciary provisions are subject to the jurisdiction of the Department of Labor, and not the IRS.)
The regulations affect sponsors, administrators, participants, and beneficiaries of qualified retirement plans and apply for taxable years beginning on or after January 1, 2015.
If you have any questions about how this guidance could affect your qualified retirement plans, or you want to implement the aforementioned, please contact any of the lawyers in our Employee Benefits and Executive Compensation Practice.
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