The IRS has issued final regulations that clarify the taxtreatment of premium payments paid by qualified definedcontribution plans for accident and health insurance where suchpayments are charged against participants' planaccounts.

Included within the final regulations is a new rule governing thetax treatment of premiums paid by defined contribution plans (andcharged against participants' account) for disability insurancethat provides replacement plan contributions when a participantbecomes disabled.

The final regulations are effective for plan years beginning on orafter Jan. 1, 2015, but taxpayers may elect to apply theregulations to earlier taxable years.

Background. Section 125 of the Codeallows employees to pay accident and health insurance premiums on apre-tax basis. The Code also excludes from a participant'staxable income all proceeds received under accident or healthinsurance policies for injuries or sickness. Additionally,Code Section 402(a) provides that distributions from qualifiedretirement plans are taxable to the participant in the year ofdistribution. Accident or Health InsurancePremiums. The final regulations reiterate that, as ageneral rule, premium payments made from qualified definedcontribution plans for accident or health insurance (includinglong-term care) are considered taxable distributions to the insuredparticipant during the year in which the premium payments aremade. Certain statutory exceptions to this general rule exist,including: (i) premiums payments made on behalf of qualified publicsafety officers (Code Section 402(l)), and (ii) premium paymentsfrom a qualified retiree health account (Code Section401(h)). Premium payments that are charged against a participant'sdefined contribution plan account are treated as a taxabledistribution and are deemed as being made by the participant, notthe employer. In other words, the transaction is the same asif the participant purchased the coverage with after-taxdollars. Therefore, proceeds received from an insurance policywhose premiums are paid by a qualified plan are generallyexcludable from the participant's gross income. NOTE: Where a participant took deductions forthe insurance premium distribution, the insurance proceeds would betaxable. Disability Insurance Premiums. The finalregulations provide that premium payments made by a qualifieddefined contribution plan for disability insurance that providesreplacement plan contributions in the event of the participantbecoming disabled are not treated as a taxable distribution to theparticipant if the following conditions are met:
  • The insurance policy provides for proceeds to be paid to theplan if the employee becomes unable to continueemployment because of disability;
  • Proceeds from the insurance policy are credited to theparticipant's plan account; and
  • The amount payable under the insurance policy does not exceedthe reasonably expected annual contributions that the participantwould have made or received during the period of disability,reduced by any other contributions made on the employee's behalfduring the disability period. (Future salary increases that theparticipant would otherwise have received during the period of thedisability may be considered in determining the "reasonablyexpected" amount of the contribution that the participant wouldhave made.)
Disability insurance policies that meet these conditions aretreated as plan investments and any proceeds received are treatedas a return on that investment as opposed to plancontributions. Thus, proceeds from the disability insurancepolicy are not subject to Code rules that limit annual plancontributions. In addition, insurance proceedsare not taxable to the participant atthe time of payment. The final regulations advise that the contribution disabilityinsurance policies can replace:
  • Pre-tax contributions that a participant would otherwise havemade during the period of disability;
  • Any related employer-paid matching contributions the employeewould have received; and
  • Any employer non-elective (or profit sharing)contributions.
Action Steps for Employers. Employersthat sponsor qualified defined contribution plans should carefullyconsider whether to provide employees with the option to purchasecontribution disability insurance through the plan on a tax-favoredbasis. Offering such disability insurance as a plan investmentoption is a fiduciary decision that will expose the employer to therisk of fiduciary liability. Accordingly, employers thatdecide to offer disability insurance are advised to engage in anobjective, thorough and analytical process to identify and selectthe right disability insurance policy.

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