Final Regulations on Tax Treatment of Qualified Retirement Plan Distributions to Pay for Accident or Health Insurance Premiums | Practical Law

Final Regulations on Tax Treatment of Qualified Retirement Plan Distributions to Pay for Accident or Health Insurance Premiums | Practical Law

The Internal Revenue Service (IRS) issued final regulations clarifying that distributions by qualified retirement plans to pay for accident or health insurance are generally taxable distributions, effective for taxable years that begin on or after January 1, 2015.

Final Regulations on Tax Treatment of Qualified Retirement Plan Distributions to Pay for Accident or Health Insurance Premiums

by Practical Law Employee Benefits & Executive Compensation
Published on 13 May 2014 • USA (National/Federal)
The Internal Revenue Service (IRS) issued final regulations clarifying that distributions by qualified retirement plans to pay for accident or health insurance are generally taxable distributions, effective for taxable years that begin on or after January 1, 2015.
On May 9, 2014, the IRS issued final regulations clarifying that under IRC Section 402(a), amounts held in a qualified plan that are attributable to employer contributions that are used to pay accident or health insurance premiums are taxable distributions unless certain exceptions apply, including exceptions for:
(79 Fed. Reg. 26838 (May 12, 2014).)
Proposed regulations were originally issued on August 20, 2007 and the final regulations generally adopt the provisions in the proposed regulations with certain changes. The final regulations apply to tax years beginning on or after January 1, 2015 but may be applied to earlier years.

Medical and Accident Benefits Paid from a Qualified Plan

The final regulations provide that a payment from a qualified retirement plan for an accident or health insurance premium is generally a taxable distribution under IRC Section 72 in the taxable year in which the premium is paid. The taxable amount is the amount of the premium charged against the participant's benefits under the plan. This includes the payment of an accident or health plan premium from unallocated contributions or forfeitures.
However, the regulations clarify that distributions of qualified retirement plan assets that are used for accident or health insurance are excludable from the gross income of the employee if they are not:
  • Paid by the employer.
  • Attributable to contributions by the employer that are excludable from the gross income of the employee.

Disability Insurance that Replaces Retirement Plan Contributions

The final regulations clarify that arrangements under which amounts are used to pay premiums for disability insurance that replace retirement plan contributions in the event of a participant's disability are not taxable if:
  • The insurance contract provides for the payment of benefits to the trust in the event of an employee's inability to continue employment because of disability.
  • The benefits paid from the employee's account do not exceed the reasonable expectation of the annual contributions that would have been made to the plan on the employee's behalf for the period of disability, reduced by any other contributions made on the employee's behalf for the period of disability within the year.

Retiree Medical Benefits under IRC Section 401(h)

The final regulations provide that the following amounts payable from an IRC Section 401(h) account to fund retiree health benefits are not includible in the gross income of the participant on whose behalf such contributions are made:
  • Amounts applied for the payment of retiree accident or health benefits.
  • Amounts for the payment of retiree accident or health coverage.
An IRC Section 401(h) account is an account under a pension plan that funds retiree health benefits. A 401(h) account can provide for the payment of benefits for retired employees, their spouses and dependents for:
  • Sickness.
  • Accident.
  • Hospitalization.
  • Medical expenses.

Distributions to Eligible Retired Public Safety Officers

The final regulations provide for an exception from gross income for distributions of up to $3,000 from retirement plans used to pay health or long-term care insurance premiums of an eligible retired public safety officer.

Example

The following example illustrates the application of the final regulations:
  • An employer sponsors a qualified profit sharing plan that provides for non-elective employer profit-sharing contributions.
  • The plan's trustee enters into a contract with a third-party insurance carrier to provide health insurance for certain plan participants.
  • The insurance contract provides for the payment of medical expenses incurred by those participants.
  • The trustee makes monthly payments of $1,000 to pay the premiums due for a participant and the participant's account balance is reduced by $1,000 at the time of each premium payment.
  • In 2015, the participant is admitted to the hospital for covered medical care and the insurer pays the hospital $5,000 for the medical care provided to the participant.
Under the final regulations, each of the payments of $1,000 constitutes a taxable distribution to the participant under IRC Section 402(a). However, the $5,000 payment to the hospital is excludable from the participant's gross income and is not treated as a distribution.

Practical Implications

Under the final regulations, beginning in 2015, payments by qualified retirement plans for accident or health insurance are treated as taxable distributions. However, amounts that are used to pay premiums for disability insurance that replace retirement contributions are not taxable if they meet certain requirements.
The final regulations build on an earlier revenue ruling in which the IRS concluded that qualified retirement plan distributions that an individual elects to have applied to pay health insurance premiums under a cafeteria plan are includible in the individual's gross income (see Practice Note, Cafeteria Plans).