On May 9, 2014, the Internal Revenue Service finalized regulations that govern the tax treatment of payments made by retirement plans to pay accident or health insurance premiums.  Under the final regulations, accident or health insurance premium payments by qualified defined contribution plans are taxable distributions to the participant unless those payments are used to pay premiums for disability insurance that replace retirement plan contributions for disabled employees.  The regulations apply for tax years beginning January 1, 2015, although taxpayers may elect to apply them to earlier years. However, amounts used to pay premiums for disability insurance that will continue retirement plan contributions on behalf of disabled employees are not taxable distributions if they meet certain conditions.

Accident and Health Insurance

In general, employees may make payments for accident and health insurance premiums on a pre-tax basis under Section 125 of the Internal Revenue Code (Code).  The Code also excludes from a participant’s gross income payments received from accident or health insurance for injuries or sickness.  However, under Code Section 402(a), distributions from retirement plans are included in a participant’s gross income and taxable in the tax year of distribution. 

Consistent with the proposed rules issued in 2007, the final Regulations clarify that payments made by qualified defined contribution plans to pay accident or health insurance premiums are taxable distributions under Code Section 402(a), unless a statutory exclusion applies (see below).  The distributions are taxable to the participant in the year in which the premiums are paid.  The taxable amount of the distribution is the amount of the premium charged against the participant’s benefits under the plan.  Additionally, premium payments that are paid from unallocated contributions or forfeitures are also taxable distributions.  Those premiums will be treated as though they were first allocated to the participant and then charged against the participant’s benefits.  Money subsequently received from the accident or health insurance for personal injuries or sickness remains excluded from gross income under the final rules.

A statutory exclusion to the inclusion in gross is for payments of accident or health benefits from a qualified retiree health account described in Code Section 401(h) for retired employees under a pension or annuity plan.  These amounts are excluded from the employee’s gross income to the extent they also are excluded under Code Sections 104, 105 or 106.  Another exception is the exclusion from gross income of up to $3,000 annually for direct payments made to an insurer to purchase accident or health insurance or qualified long-term care insurance for eligible retired public safety officers under Code Section 402(l).

Disability Insurance

The proposed regulations asked for comments regarding how payments for disability insurance premiums should be treated in the final rules.  The preamble to the final Regulations states that every comment submitted suggested that premium payments should be tax free if they replace a participant’s contributions to the plan.  Many commenters argued that a qualified plan’s premium payments for the purchase of disability insurance are distinguishable from the purchase of medical insurance because disability payments are intended to replace a participant’s contributions to the plan, rather than providing medical benefits outside of the plan.  For this reason, disabled employees should not be taxed when disability payments are sent to their retirement accounts because those contributions will be taxed when the retirement benefits are distributed.

These arguments were largely persuasive.  Accordingly, the final Regulations provide that payments of disability insurance premiums from a qualified plan are not taxable if both of the following conditions are satisfied: 

• The insurance contract provides for benefit payments to be made to the plan in the event of an employee’s inability to continue employment because of disability 

• The benefits paid to a participant’s account do not exceed the reasonably expected annual contributions that the employee would have received during the period of disability, reduced by any other contributions made on the employee’s behalf during the disability period

Meeting these conditions results in disability insurance being treated as a plan investment and the plan’s premium payments and the insurance’s benefit payments to the plan are not taxable to the participant.  If these conditions are not met, the premium payments would become taxable distributions to the employee under Code Section 402(a) and benefits paid to the plan would be deemed contributions.

The final regulations were published in the Federal Register on May 12, 2014, and apply to plan years beginning on or after January 1, 2015, though taxpayers may apply them to earlier years.

Next Steps

Employers that sponsor qualified defined contribution plans may consider giving employees the option to purchase disability insurance on a tax-favored basis.  Employees who choose to purchase coverage will have the benefit of knowing contributions to their retirement accounts will continue should they become disabled and unable to continue working.  Employers will need to review the terms of their plans to determine if adding disability insurance will require a plan amendment.