Key Development: The regulations may prompt employers waiting for guidance to begin offering long-term disability benefits.
Key Takeaway: The regulations provide clarity for employers offering the benefit under their plan.
By Marvin Anderson
May 13 — Final regulations the Treasury Department recently released providing guidance on the taxation of retirement plan payments for health and accident insurance, including disability coverage, leave employers with an opportunity to offer a benefit they wanted to include for years, according to benefits consultant Anna Rappaport.
Employees lost a long-term disability benefit when employers switched from defined benefit plans to defined contribution plans, Rappaport, president of Anna Rappaport Consulting and former president of the Society of Actuaries, said May 13.
But the regulations allow defined contribution plans to include provisions that would help participants continue saving for retirement while on disability, she said, similar to a waiver premium in life insurance. That long-term disability benefit for defined contribution plans was largely unavailable and a big concern, she said, until the final regulations were released.
The final regulations (T.D. 9665), released May 9 by Treasury and the Internal Revenue Service, provide that payments from a qualified defined contribution plan to pay a participant’s accident and health insurance premiums are taxable distributions to the participant unless a statutory exception applies. They also provide an exception under which disability insurance premiums are not taxable distributions if they meet certain conditions (91 DTR G-7, 5/12/14).
For disability premiums to meet the standards, they must be paid directly from the plan, the plan must receive the benefit payments as required by the contract, the benefit payments under the contract must be paid because the employee is on disability and unable to work, and the benefit payments to the participant’s account can’t exceed a reasonable expectation of what the participant would have received if not on disability, the IRS said.
The final regulations said that the IRS commissioner may issue rules of general applicability in revenue rulings, notices or other guidance published in the Internal Revenue Bulletin further describing the tax treatment of disability coverage on the exception for disability insurance.
This may encourage employers to consider offering disability coverage, and encourage more employees to participate if their employers do offer the benefit, Rappaport said.
Clarity for Employers
The Treasury Department guidance included more provisions than what the employee benefits industry expected, said Richard C. Shea, a partner at Covington & Burling LLP in Washington. With regards to the disability exception, one of the unexpected provisions allows employers to increase contributions that match salary increases that an employee was expected to earn if he or she were not on disability leave, he said.
The regulations, Shea said, also assure employers that providing disability protection options will not have an adverse effect or cause tax complications for individuals in a plan.
“They really went out of their way to bless these arrangements and to do something helpful,” said Shea, whose firm has many large employer clients interested in offering these programs and one that has run a program since 2005.
To provide employees with disability protection options, employers began to amend defined contribution plans to allow participants to use a portion of an account to pay premiums for disability protection, Shea said. That coverage provides payments to an employee’s retirement account to replace contributions lost during disability leave.
An employee who is disabled at age 50 and does not return to work until age 55 loses five years of retirement savings that may be impossible to make up over the remainder of a working career, Shea said.
“Long-term disability benefits can replace the employee’s current income, but generally do not make up for the employee’s lost retirement savings during disability,” Shea had said in 2012 written testimony to the ERISA Advisory Council. “The inability to save during an extended disability can permanently undermine an employee’s retirement savings.”
The adoption of insured replacement benefit programs for disabled employees was at a standstill, he said, but now, with the new regulations, employers have the guidance needed to successfully enact these policies.
“Not everyone is going to do this, but clearly companies that already had it cared very much about it,” he said. “They thought they were doing a good thing and they wanted to keep doing it without getting in trouble.”