Most qualified plan distributions to pay accident or health premiums are taxable

Final regulations exclude amounts to pay for disability insurance replacing retirement contributions.

The IRS finalized regulations providing that distributions from qualified retirement plans to pay accident or health insurance premiums are taxable unless a statutory exclusion applies. However, arrangements where amounts are used to pay premiums for disability insurance to replace retirement plan contributions in the event of a participant’s disability are not treated as taxable under the regulations if they meet certain requirements. The rules finalize proposed regulations from 2007 (REG-148393-06), with a few modifications.

One of the statutory exclusions from the general rule is under Sec. 402(l) of 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. Another is under Sec. 401(h) for payments for similar coverage for other retired employees.

The proposed regulations reserved the tax treatment of payments to provide disability insurance, asking for comments on how they should be treated in the final rules. The IRS agreed with the gist of many comments that a qualified plan’s purchase of this type of disability coverage is distinguishable from the purchase of medical insurance because the functional purpose of the disability insurance coverage is to replace retirement contributions to the plan instead of providing medical benefits outside the plan.

Accordingly, under the final rules, the payment of disability insurance premiums from a qualified plan is not taxable if it meets the following requirements: The insurance contract provides for payment of benefits to the trust in the event of an employee’s inability to continue employment because of disability, but the benefits paid from an employee’s account cannot exceed the reasonable expectation of the annual contributions that would have been made to the qualified 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.

The final regulations apply to tax years beginning on or after Jan. 1, 2015, but taxpayers may apply them to earlier years.

– T.D. 9665

By Sally P. Schreiber, J.D., a JofA senior editor.