The IRS has issued final regulations that clarify the tax treatment of premium payments paid by qualified defined contribution plans for accident and health insurance where such payments are charged against participants' plan accounts. Included within the final regulations is a new rule governing the tax treatment of premiums paid by defined contribution plans (and charged against participants' account) for disability insurance that provides replacement plan contributions when a participant becomes disabled. The final regulations are effective for plan years beginning on or after January 1, 2015, but taxpayers may elect to apply the regulations to earlier taxable years.
Background. Section 125 of the Code allows employees to pay accident and health insurance premiums on a pre-tax basis. The Code also excludes from a participant's taxable income all proceeds received under accident or health insurance policies for injuries or sickness. Additionally, Code Section 402(a) provides that distributions from qualified retirement plans are taxable to the participant in the year of distribution.
Accident or Health Insurance Premiums. The final regulations reiterate that, as a general rule, premium payments made from qualified defined contribution plans for accident or health insurance (including long-term care) are considered taxable distributions to the insured participant during the year in which the premium payments are made. Certain statutory exceptions to this general rule exist, including: (i) premiums payments made on behalf of qualified public safety officers (Code Section 402(l)), and (ii) premium payments from a qualified retiree health account (Code Section 401(h)).
Premium payments that are charged against a participant's defined contribution plan account are treated as a taxable distribution and are deemed as being made by the participant, not the employer. In other words, the transaction is the same as if the participant purchased the coverage with after-tax dollars. Therefore, proceeds received from an insurance policy whose premiums are paid by a qualified plan are generally excludable from the participant's gross income.
NOTE: Where a participant took deductions for the insurance premium distribution, the insurance proceeds would be taxable.
Disability Insurance Premiums. The final regulations provide that premium payments made by a qualified defined contribution plan for disability insurance that provides replacement plan contributions in the event of the participant becoming disabled are not treated as a taxable distribution to the participant if the following conditions are met:
- The insurance policy provides for proceeds to be paid to the plan if the employee becomes unable to continue employment because of disability;
- Proceeds from the insurance policy are credited to the participant's plan account; and
- The amount payable under the insurance policy does not exceed the reasonably expected annual contributions that the participant would have made or received during the period of disability, reduced by any other contributions made on the employee's behalf during the disability period. (Future salary increases that the participant would otherwise have received during the period of the disability may be considered in determining the "reasonably expected" amount of the contribution that the participant would have made.)
Disability insurance policies that meet these conditions are treated as plan investments and any proceeds received are treated as a return on that investment as opposed to plan contributions. Thus, proceeds from the disability insurance policy are not subject to Code rules that limit annual plan contributions. In addition, insurance proceeds are not taxable to the participant at the time of payment.
The final regulations advise that the contribution disability insurance policies can replace:
- Pre-tax contributions that a participant would otherwise have made during the period of disability;
- Any related employer-paid matching contributions the employee would have received; and
- Any employer non-elective (or profit sharing) contributions.
Action Steps for Employers. Employers that sponsor qualified defined contribution plans should carefully consider whether to provide employees with the option to purchase contribution disability insurance through the plan on a tax-favored basis. Offering such disability insurance as a plan investment option is a fiduciary decision that will expose the employer to the risk of fiduciary liability. Accordingly, employers that decide to offer disability insurance are advised to engage in an objective, thorough and analytical process to identify and select the right disability insurance policy.
Before an employer decides to offer contribution disability insurance as an investment option under its qualified defined contribution plan, the underlying plan document must be reviewed to determine what amendments are needed. Employers are advised to engage qualified employee benefits counsel to assist in the plan document review and amendment process.
NOTE: Marcia Wagner testified before the Internal Revenue Service regarding the appropriate treatment of disability insurance in the context of defined contribution plans and the very position that she espoused, by virtue of the regulations, is now the law of the land.