IRS Issues Final Regulations on Tax Treatment of Qualified Retirement Plans for Accident or Health Insurance

Targeted News Service

WASHINGTON, May 12 -- The Internal Revenue Service published the following rule in the Federal Register:

Tax Treatment of Qualified Retirement Plan Payment of Accident or Health Insurance Premiums

A Rule by the Internal Revenue Service on 05/12/2014

Publication Date: Monday, May 12, 2014

Agencies: Department of the Treasury

Internal Revenue Service

Entry Type: Rule

Action: Final regulations.

Document Citation: 79 FR 26838

Page: 26838 -26843 (6 pages) CFR: 26 CFR 1

Agency/Docket Number: TD 9665

RIN: 1545-BG12

Document Number: 2014-10849

Shorter URL: https://federalregister.gov/a/2014-10849

Action

Final Regulations.

Summary

This document contains final regulations clarifying the rules regarding the tax treatment of payments by qualified retirement plans for accident or health insurance. The final regulations set forth the general rule under section 402(a) that amounts held in a qualified plan that are used to pay accident or health insurance premiums are taxable distributions unless described in certain statutory exceptions. The final regulations do not extend this result to arrangements under which amounts are used to pay premiums for disability insurance that replaces retirement plan contributions in the event of a participant's disability. These regulations affect sponsors, administrators, participants, and beneficiaries of qualified retirement plans.

DATES:

Effective Date: These regulations are effective on May 12, 2014.

Applicability Date: These regulations generally apply for taxable years that begin on or after January 1, 2015. However, taxpayers may elect to apply the regulations to earlier taxable years. See the "Effective/Applicability Dates" section in this preamble for additional information regarding the applicability of these regulations.

FOR FURTHER INFORMATION CONTACT:

Michael P. Brewer or Lauson C. Green at (202) 317-6700 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

This document contains amendments to 26 CFR part 1 under section 402(a) of the Internal Revenue Code (Code), as well as conforming amendments under sections 72, 105, 106, 401, 402(c), 403(a), and 403(b).

Section 104(a)(3) provides, in general, that gross income does not include amounts received through accident or health insurance (or through an arrangement having the effect of accident or health insurance) for personal injuries or sickness. This exclusion does not apply to amounts attributable to (and not in excess of) deductions allowed under section 213 for any prior taxable year, or to other amounts received by an employee to the extent the amounts either are attributable to contributions by the employer that were not includible in the gross income of the employee or are paid by the employer.

Section 105(a) provides that, except as otherwise provided, amounts received by an employee through accident or health insurance for personal injuries or sickness are included in gross income to the extent the amounts (1) are attributable to contributions by the employer that were not includible in the gross income of the employee or (2) are paid by the employer.

Section 105(b) generally provides that, except in the case of amounts attributable to deductions allowed under section 213 for any prior taxable year, gross income does not include amounts referred to in section 105(a) if the amounts are paid, directly or indirectly, to the taxpayer to reimburse the taxpayer for expenses incurred by the taxpayer for the medical care of the taxpayer and his or her spouse or dependents (as defined in section 152, determined without regard to paragraphs (b)(1), (b)(2), and (d)(1)(B) thereof) and any child (as defined in section 152(f)(1)) of the taxpayer who as of the end of the taxable year has not attained age 27.

Section 106(a) provides that, except as otherwise provided, the gross income of an employee does not include employer-provided coverage under an accident or health plan. Section 1.106-1 of the Income Tax Regulations provides that the gross income of an employee does not include contributions that the employer makes to "an accident or health plan for compensation (through insurance or otherwise) to the employee for personal injuries or sickness incurred" by the employee or the employee's spouse or dependents.

For purposes of the Code, section 7702B(a) treats a qualified long-term care insurance contract as an accident and health insurance contract, and a plan of an employer providing coverage under a qualified long-term care insurance contract as an accident and health plan with respect to that coverage.

Section 213 generally allows a deduction for expenses paid during the taxable year, not compensated for by insurance or otherwise, for medical care of the taxpayer and the taxpayer's spouse and dependents, to the extent that the expenses exceed 10 percent of the taxpayer's adjusted gross income. [1] Section 213(d)(1) provides that the term "medical care" includes amounts paid for insurance covering medical care (including eligible long-term care premiums with respect to qualified long-term care insurance contracts).

Section 401(a) sets forth requirements for a trust forming part of a pension, profit-sharing, or stock bonus plan to be qualified under section 401(a).

Section 401(h) provides that a pension or annuity plan may provide for the payment of benefits for sickness, accident, hospitalization, and medical expenses of retired employees, their spouses and their dependents only if certain enumerated conditions are met. Those conditions include: (1) The aggregate actual contributions for medical benefits (when added to actual contributions for life insurance protection under the plan) may not exceed 25 percent of the total actual contributions to the plan (other than contributions to fund past service credits) after the date on which the account is established; (2) a separate account must be established and maintained for such benefits; (3) the employer's contributions to the separate account must be reasonable and ascertainable; (4) it must be impossible, at any time prior to the satisfaction of all liabilities under the plan to provide such benefits, for any part of the corpus or income of such separate account to be (within the taxable year or thereafter) used for, or diverted to, any purpose other than the providing of such benefits; (5) any amount remaining after satisfaction of all liabilities must, under the terms of the plan, be returned to the employer; and (6) special limitations for the accounts of key employees (as defined in section 401(h)) must be satisfied.

Section 402(a) provides, in general, that any amount actually distributed by a qualified plan is taxable under section 72 in the taxable year in which distributed.

Section 72(a) provides that, except as otherwise provided, gross income includes any amount received as an annuity (whether for a period certain or during one or more lives) under an annuity, endowment, or life insurance contract. Sections 72(d) and (e), which apply to any amount received as an annuity and any amount not received as an annuity, respectively, provide rules for determining the portion of any distribution that is not includable in gross income as a recovery of a participant's investment in the contract (generally the amount of the unrecovered after-tax employee contributions) under a qualified employer retirement plan.

Section 402(l) provides a limited exclusion from gross income for distributions from an eligible retirement plan used to pay health or long-term care insurance premiums of an eligible retired public safety officer to the extent that the aggregate amount of the distributions for the taxable year is not in excess of the qualified health insurance premiums of the retired public safety officer and his or her spouse or dependents. The total amount excluded from gross income pursuant to section 402(l) is limited to $3,000.

Section 1.72-15 provides rules relating to the tax treatment of amounts paid from an employer-established plan to which section 72 applies and which provides for distributions of accident or health benefits. With respect to benefits that are attributable to employer contributions, section 1.72-15(d) provides that any amount received as an accident or health benefit is includible in gross income, except to the extent excludable from gross income under section 105(b) (relating to reimbursements of medical care expenses as defined in section 213(d)). [2] Section 1.72-15(e) provides that the taxability of benefits that are not accident or health benefits is determined under section 72 without regard to any exclusion under section 104 or 105.

Section 1.401-1(b)(1)(i) provides that a plan is not a pension plan within the meaning of section 401(a) if it provides for the payment of benefits not customarily included in a pension plan, such as layoff benefits or benefits for sickness, accident, hospitalization, or medical expenses (except for medical benefits described in section 401(h)).

Section 1.401-1(b)(1)(ii) provides that a profit-sharing plan within the meaning of section 401(a) is primarily a plan of deferred compensation, but that amounts allocated to the account of a participant may be used to provide incidental life or accident or health insurance for the participant and the participant's family. Section 1.401-1(b)(1)(iii) provides that a stock bonus plan is a plan established and maintained by the employer to provide benefits similar to those of a profit-sharing plan.

Rev. Rul. 61-164 (1961-2 CB 99) (see section 601.601(d)(2)(ii)(b)) holds that a profit-sharing plan does not violate the incidental benefit rule in section 1.401-1(b)(1)(ii) merely because, in accordance with the plan's terms, each participant's account under the plan is charged with the cost of health insurance for the participant under group hospitalization insurance for the employer's employees, provided that the total amount used for life or accident or health insurance for the employee and the employee's family is incidental. The ruling also holds that the use of profit-sharing plan funds to pay for medical insurance for a participant and his or her beneficiary is a distribution within the meaning of section 402.

Rev. Rul. 73-501 (1973-2 CB 127) (see section 601.601(d)(2)(ii)(b)) applies the incidental benefit rule to the purchase of life insurance by a profit-sharing plan. The ruling states that "[u]nder a qualified profit-sharing plan, the use of trust funds to pay the cost of life, accident, or health insurance for an employee is a distribution within the purview of section 402 of the Code."

Rev. Rul. 2003-62 (2003-1 CB 1034) holds that amounts distributed from a qualified retirement plan that the distributee elects to have applied to pay health insurance premiums under a cafeteria plan are includible in the distributee's gross income. The ruling also holds that the same conclusion applies if amounts distributed from the plan are applied directly to reimburse medical care expenses incurred by a participant.

Rev. Rul. 2005-55 (2005-2 CB 284) holds that a profit-sharing plan that provides a sub-account that permits distributions only for the purpose of reimbursing the participant for substantiated medical expenses imposes conditions on the entitlement of the participant to amounts held in the sub-account and, as a result of the conditions, does not meet the nonforfeitability requirements of section 411.

Proposed regulations (REG-148393-06) under section 402(a) (proposed regulations) were published by the Treasury Department and the IRS in the Federal Register on August 20, 2007 (72 FR 46421). Corrections to the proposed regulations were published in Announcement 2007-98 (2007-2 CB 896). The Treasury Department and the IRS received written comments on the proposed regulations and a public hearing was held on December 6, 2007.

After consideration of the comments received in response to the proposed regulations, these final regulations generally adopt the provisions of the proposed regulations with certain modifications as described under the heading "Summary of Comments and Explanation of Provisions."

Summary of Comments and Explanation of Provisions

General Treatment of Accident or Health Insurance

Consistent with the proposed regulations, the final regulations clarify that a payment from a qualified plan for an accident or health insurance premium generally constitutes a distribution under section 402(a) that is taxable to the distributee under section 72 in the taxable year in which the premium is paid. The taxable amount generally equals the amount of the premium charged against the participant's benefits under the plan. If a defined contribution plan pays these premiums from a current year contribution or forfeiture that has not been allocated to a participant's account, then the amount of the premium for each participant will be treated as first being allocated to the participant and then charged against the participant's benefits under the plan. Therefore, the payment of an accident or health plan premium from unallocated contributions or forfeitures also will constitute a distribution to the participant under section 402(a) that is taxable under section 72 in the taxable year in which the premium is paid.

Like the proposed regulations, these regulations provide that a distribution for the payment of the premiums by a qualified plan generally is not excluded from gross income under sections 104, 105, or 106. However, the distribution may constitute a payment for medical care under section 213. Furthermore, to the extent that the payment of premiums for accident or health insurance has been treated as a distribution from a qualified plan, amounts received through the accident or health insurance for personal injuries or sickness are excludable from gross income under section 104(a)(3) and are not treated as distributions from the plan.

The general rule that the payment of an accident and health insurance premium from a qualified plan constitutes a distribution that is taxable under section 402 does not apply if another statutory provision provides for a different result. For example, section 402(l) provides an exclusion from gross income, up to $3,000 annually, for distributions paid directly to an insurer to purchase accident or health insurance or qualified long-term care insurance for an eligible retired public safety officer and his or her spouse or dependents. A similar exclusion applies for medical benefits for retired employees provided from an account described in section 401(h).

In accordance with these regulations, as with the proposed regulations, if a payment of a premium for accident or health insurance is treated as a distribution from the trust, then the insurance contract would not be treated as an investment under which the insurer's payments to the trust are treated as a return on that investment. As a result, payments from such a contract that are made to the trust (rather than made to the medical service provider or the participant as reimbursement for covered expenses) are treated as having been made to the participant and then contributed by the participant to the plan.

Special Rule for Disability Insurance Coverage

The preamble to the proposed regulations requested comments on whether there should be limited exceptions to the general rule in the proposed regulations, including whether there should be an exception for a provision that has the effect of a waiver of premium in the case of disability. All of the commenters that addressed the issue of payment of premiums for disability insurance from a plan recommended an exception for disability insurance arrangements that replace retirement plan contributions, describing these arrangements as having the same effect as a waiver of premiums in the case of disability. For example, commenters described an employer's general disability program that not only provides for wage replacement, but also provides for the purchase of insurance to make payments to a qualified plan in the event of a participant's disability that are intended to replace the contributions that would have been made if the participant was not disabled. These commenters requested that the regulations provide that a participant not be currently taxable on the premiums paid by the plan for this type of disability coverage. Similarly, they recommended the participant not be taxed when payments from the disability insurance contract are allocated to the participant's account after the participant becomes disabled. These comments pointed out that the payments would be taxable when benefits are ultimately distributed from the plan.

The Treasury Department and the IRS agree that the purchase of this type of disability coverage by a qualified plan is distinguishable from the purchase of medical insurance by a plan because the functional purpose of the disability insurance coverage is to replace retirement contributions to the plan, instead of providing medical benefits outside of the plan. Accordingly, these final regulations provide an exception for the payment of disability insurance premiums from a qualified plan if the insurance contract provides for payment of benefits to be made to the trust in the event of an employee's inability to continue employment with the employer due to disability, provided that the payment of benefits with respect to an employee's account does not exceed the reasonable expectation of the annual contributions that would have been made to the plan on the employee's behalf during the period of disability, reduced by any other contributions made on the employee's behalf for the period of disability within the year. For example, under this standard, the payment of benefits with respect to an employee's account may increase to reflect reasonably expected future salary increases. To the extent these conditions are satisfied, the insurance does not constitute a distribution to which section 402(a) applies and instead will be treated as any other plan investment. However, if the insurance contract provides for payment of benefits that exceed the reasonable expectation of the annual contributions that would have been made to the plan on the employee's behalf during the period of disability, then the exception for disability coverage would not apply and all of the premium payments made to provide the benefits to the employee would be treated as distributed to the employee under section 402(a) and (as described in this preamble) benefits from the coverage paid to the plan would constitute contributions. This limitation on the benefits payable under a contract is consistent with treating the disability coverage as a waiver of premium in case of disability, similar to the provision in section 1.408-3(a) under which a contract is not treated as other than an individual retirement annuity merely because it provides for waiver of premium upon disability. Additionally, the limitation means that benefits provided by the plan in the event of disability generally will be comparable to the disability benefits provided by a qualified disability benefit under a defined benefit plan, as described in section 411(a)(9) and section 1.411(a)-7(c)(3).

Some commenters recommended that the exception for disability coverage not result in different tax treatment for plan participants depending upon whether their employer insured or self-insured the disability benefit. The final regulations only address the situation in which payment of premiums is made from the plan. The Treasury Department and the IRS have concluded that, to the extent the insurance premiums are not paid by the plan or out of contributions to the plan, the disability insurance contract is not an asset of the plan and the amounts received by the plan under the disability insurance contract are not properly treated as a return on a plan investment. Instead, in such a case, the amounts paid from the insurance contract to the plan would be treated as contributions to the plan and would be subject to the general rules that apply to qualified plan contributions, including section 415(c). Similarly, to the extent the employer self-insures or makes arrangements to finance the disability coverage other than through third party insurance, the amounts paid to the plan on account of disability would be considered a contribution to the plan and would be subject to the general rules that apply to qualified plan contributions, including section 415(c). Payments to the plan will not be properly characterized as a return on a plan investment in any of these situations.

Conforming Amendments

The regulations contain conforming amendments to the Income Tax Regulations under sections 72, 105, 106, 401, and 402(c). These conforming amendments remove obsolete provisions, as well as cite to the rules in these regulations for determining the tax treatment of the payment of premiums for accident and health insurance from a qualified plan. [3]

Conforming amendments to the regulations under sections 403(a) and 403(b) also add a cross-reference applying these rules under section 402(a) to sections 403(a) and 403(b) arrangements. As a result, amounts paid for disability insurance premiums from an annuity or account under section 403(a) or 403(b) do not constitute distributions (and the disability insurance contracts are treated as plan investments) if the requirements applicable to the purchase of disability insurance by qualified plans are met. As in the case of a plan described in section 401(a), if the plan sponsor of an annuity or custodial account under section 403(a) or section 403(b) financed the disability protection by paying premiums for disability insurance that provides coverage to protect against a loss of contributions during a period of disability, then the benefits paid by the disability insurer would be treated as employer contributions to the annuity or account. However, if the premiums for the disability insurance were paid from the annuity or account in accordance with the rules that apply to qualified plans, then the benefits paid by the disability insurer will be treated as a return on plan investment.

In addition, the regulations revise the first sentence of section 1.106-1 in order to update the definition of the term "dependent" to reflect section 207 of the Working Families Tax Relief Act of 2004, Public Law 108-311 (118 Stat. 1166 (2004)) and Notice 2004-79 (2004-2 CB 898) and to reflect the amendment of section 105(b) made by section 1004(d)(1) of the Health Care and Education Reconciliation Act of 2010, Public Law 111-152 (124 Stat. 1029 (2010)), to include certain children who have not attained age 27. For periods before the applicability date of the regulations, taxpayers can rely on the interpretation of this latter provision set forth in Notice 2010-38 (2010-20 IRB 682).

These regulations also include a cross-reference to section 402(l) and amend section 1.402(c)-2, Q&A-4, to add distributions of premiums for accident or health insurance under section 1.402(a)-1(e)(1) to the list of items that are not eligible rollover distributions.

Effective/Applicability Date

The regulations apply for taxable years beginning on or after January 1, 2015. No inference should be drawn that the payment of accident or health premiums from a qualified plan does not constitute a taxable distribution if made in an earlier taxable year. However, taxpayers may elect to apply the regulations to earlier taxable years.

Statement of Availability of IRS Documents

The recently issued IRS notices and revenue rulings cited in this preamble are published in the Internal Revenue Bulletin or Cumulative Bulletin and are available from the Superintendent of Documents, P.O. Box 979050, St. Louis, MO 63197-9000, or by visiting the IRS Web site at http://www.irs.gov.

Special Analyses

It has been determined that these regulations are not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations, and because these regulations do not impose a collection of information on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Code, the proposed regulations preceding these final regulations were submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Drafting Information

The principal authors of these regulations are Michael P. Brewer and Lauson C. Green, Office of Division Counsel/Associate Chief Counsel (Tax Exempt and Government Entities). However, other personnel from the IRS and the Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

Income taxes

Reporting and recordkeeping requirements

[*Federal RegisterVJ 2014-05-12]

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