The Treasury Department and the Internal Revenue Service have published final regulations that allow employers to adopt insured plan contribution replacement benefit programs for disabled employees. Up until now, if a participant could not work due to a disability, the participant was unable to defer salary or receive employer contributions under a defined contribution retirement plan, such as a 401(k) plan.
Now, if an employer purchases a special disability policy, the policy will make payments to the defined contribution plan for the benefit of disabled participants. The payments are even allowed to increase to reflect reasonably expected future salary increases. The insurance policy can make up for any pre-tax contributions that an employee would have made while disabled, any employer matching amounts and any profit-sharing contributions. There is no guidance as to how these amounts are to be calculated.
If conditions are met, participants will not be taxed on the amount of premiums paid and disabled participants will not be immediately taxed on the amounts contributed to the plan by the policy.
Final regulations state that payments from a qualified defined contribution plan to pay a participant’s disability insurance premiums aren’t taxable distributions if they meet certain conditions.
The regulations are effective January 1, 2015, but may be applied earlier.
The final regulations include an exception for disability insurance premiums being taxed to participants if the following conditions are met:
- Premiums for the disability insurance contract are paid directly from the plan.
- The plan receives the benefit payments as required by the disability insurance contract.
- Benefit payments under the contract are paid because of an employee’s inability to continue employment with the employer because of disability.
- The benefit payments to a participant’s account aren’t more than a reasonable expectation of what the participant would’ve received as an annual contribution during the disability period, reduced by any other contributions.
If these conditions are satisfied, the disability insurance is considered a plan investment, and the plan’s premium payments and the insurance’s benefit payments to the plan aren’t taxable to the participant.
If the disability insurance premiums aren’t paid by the plan, the insurance benefits paid to the plan aren’t a return on a plan investment. Instead, these payments are contributions to the plan governed by qualified plan contribution rules (generally, IRC Section 415(c), which limits employer contributions to a defined contribution plan).
If an employer self-funds this disability coverage (or doesn’t finance it through third party insurance), the amount paid to the plan because of the employee’s disability is also considered a contribution to the plan governed by the general qualified plan contribution rules.
The final regulations add the exception for nontaxability of disability insurance based on comments received on the 2007 proposed regulations, which:
- recommended that disability insurance designed to protect against the loss of plan contributions during a period of disability should be excluded from the general taxable distribution rule, and
- noted that the participant would be taxed on these insurance benefits when they are distributed from the plan. Employers that sponsor defined contribution plans will need to decide if they want to all employees to choose to purchase disability insurance. Plan sponsors wishing to take advantage of this new provision will need to amend their plan documents to permit the plan to hold the special disability policies, make the premium payments and allocate benefits to the accounts of disabled participants.