The Treasury Department and the IRS released final regulations regarding amounts used by a qualified plan to pay for accident or health insurance premiums. Under the regulations, there is one notable exception created for insurance that pays benefits to the plan on behalf of a participant while he or she is unable to work due to disability.
The final regulations allow employers to adopt insured "plan contribution replacement" benefit programs for disabled employees.
On May 9, 2014, the U.S. Department of the Treasury and the Internal Revenue Service released final regulations regarding amounts from a qualified plan that are used to pay for accident or health insurance premiums. The final regulations generally adopt the provisions of the proposed regulations published in August 2007, with one notable exception created for insurance that makes contributions on behalf of a participant while he or she is unable to work due to disability.
Under the proposed regulations and the final regulations, amounts from a qualified plan used to pay for accident or health insurance premiums generally are taxable distributions under Section 402(a) of the Internal Revenue Code unless a statutory exception applies. If the premiums are paid from a contribution or forfeiture that has not yet been allocated to a participant's account, the payment will first count as being paid to the participant and then contributed by the participant to the plan. In addition, the payment made by the plan will count as a taxable distribution to the participant under Section 402(a).
Premiums Not Taxable Under Specific Conditions
However, the general rule does not apply to special "plan contribution replacement" disability insurance policies that pay benefits to a participant's account during the period of the participant's disability. Normally, if the participant stops working due to a disability, the participant is unable to continue making salary deferrals and receiving employer contributions under the plan. Under the special disability policy, if a participant is not working during a disability period, the policy will make payments to the plan for the benefit of the participant. The final regulations make an exception for payments by a plan for the premiums for such special disability policies. If certain conditions are met, the premium payments by the plan are not treated as taxable distributions and the benefits paid to the participant's account in the plan are treated as investment earnings rather than contributions.
The exception for the special disability policies applies only if all of the following conditions are met:
the premium payments must be paid directly from the plan
the benefit payments must be paid because the employee is on disability and unable to work
the benefit payments to the participant's account cannot exceed the "reasonable expectation" of the annual contributions that would have been made on the participant's behalf if not disabled
the amount paid under the policy must be reduced by any other contributions made on the participant's behalf during the period of disability
Benefit Payments Allowed to Increase
The payments of benefits under the policy are allowed to increase to reflect reasonably expected future salary increases. However, if the special disability insurance premium is not paid by the plan or out of contributions to the plan, then amounts received by the plan under the disability insurance contract will be treated as contributions to the plan and be subject to the general rules that apply to qualified plan contributions. Further, if the employer does not finance the disability coverage through third-party insurance, then the amounts paid to the plan will also be considered contributions to the plan. Although it appears that the special disability policy would have to be owned by the plan, it appears that the participant could negotiate the terms of the policy. The plan document likely would need to be amended to permit the plan to hold the special disability policy, make the premium payments and allocate any benefits paid to the account of the insured participant.
The final regulations apply for taxable years beginning on or after January 1, 2015, though taxpayers may elect to apply the regulations to earlier taxable years.
Employers should consider the following steps:
The employer should evaluate whether its employees will be interested in the special "plan contribution replacement" disability insurance that allows an employee on disability to replace the retirement plan savings that will be lost during a period of disability.
The employer should discuss with its insurance or benefits broker the types of policies that are available and the schedule of premiums that are applicable to the policies.
If the employer wants to offer the special disability insurance, it should consult with its ERISA attorney concerning whether the plan needs to be amended and whether there are other ERISA and tax issues that need to be addressed.
To ensure compliance with Treasury Regulations (31 CFR Part 10, §10.35), we inform you that any tax advice contained in this correspondence was not intended or written by us to be used, and cannot be used by you or anyone else, for the purpose of avoiding penalties imposed by the Internal Revenue Code.