In proposed regulations published August 20, 2007, the Internal Revenue Service seeks to clarify its general rule that any disbursement from a qualified plan that is used to pay health or accident premiums for a plan participant will be treated as a taxable plan distribution. Though the proposed regulations are expected to apply for calendar years following publication of final regulations, the IRS specifically states that no inference should be drawn that health insurance premium payments from qualified plans prior to the effective date of final regulations can be treated as non-taxable.
The proposed regulations are consistent with a 2003 Revenue Ruling in which the IRS concluded that qualified retirement plan distributions are treated as taxable distributions to a participant when either (a) the participant elects to have the distributions applied to pay health insurance premiums under a cafeteria plan, or (b) the distributions are directly applied to reimburse the participant’s medical care expenses. However, the proposed rules effectively extend such treatment of any such premium payments as distributions, which arguably might result in violations of in-service distribution rules and the 10% excise tax on early plan distributions.
The new proposed rules would not alter existing regulations with respect to (a) retiree medical accounts allowed in pension plans under section 401(h) of the Internal Revenue Code, or (b) retired public safety officials’ use of up to $3,000 per year in disbursements to pay qualified health insurance premiums. However, they do appear to modify prior IRS positions that allowed plans to hold certain insurance policies as an investment and treat benefit payments from the insurer to the plan as a return on that investment (e.g., a disability policy with benefit payments to essentially replace contributions that would have been made on the participant’s behalf during a period of disability).
The IRS proposes that payments from the insurer to the plan would be treated as having first been made to the participant and then contributed by the participant to the plan, which, due to various qualified plan rules, would make holding such insurance problematic.
The IRS has requested comments on the proposed regulations before they are finalized. In the meantime, sponsors of qualified retirement plans that allow payment of health insurance premiums (including premiums for disability and long-term care insurance) on a tax-favored basis should review such plans immediately in light of the proposed regulations.