“Apparently we have a rider in our group long-term disability (LTD) plan that provides for such a benefit, so that such employees do not miss out on their retirement plan contributions due to disability. I have never seen these contributions before; does the Internal Revenue Service (IRS) permit such a benefit? And how are such contributions treated for tax purposes?”
Michael A. Webb, vice president, Cammack Retirement Group, answers:
Your question is quite timely since the IRS recently released final regulations in this regard (see summary here). Such insurance payments for disabled employees are indeed permissible, and are not taxable to participants at the time the amounts are remitted to the retirement plan, provided that 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; and
- 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.
In the Experts experience, however, the premiums for such insurance are often not paid directly by the plan, but by the employee, the employer or a combination of both. 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, if contributed to the plan, these payments are contributions to the plan governed by qualified plan contribution rules (generally, IRC Section 415(c), which limits contributions to a defined contribution plan, particularly 415(c)(3)(C) which applies to contributions while permanently and totally disabled).
Furthermore, even if not taxable upon contribution to the plan, this does NOT mean that the benefit is completely tax-free. Upon distribution of the participant’s account balance, these contributions would be taxable to the participant is a manner similar to any other plan benefit (with a waiver of the 10% premature distribution penalty in the event of total disability).
Though such contributions are permissible, in actual plan operation, they are often problematic from a compliance perspective. Such contributions are often misclassified in the retirement plan, or not remitted properly, due to the fact that the source of the contributions, the plan’s long-term disability carrier, is unfamiliar with retirement plans. Administration is often a manual process, which can also lead to errors. It is for this reason that some disability carriers provide such a benefit outside of the retirement plan, in a separate trust administered by the insurer. If a plan sponsor chooses to provide such a benefit within the retirement plan, it should work with benefits counsel well-versed in such matters to ensure that no operational failures occur.
NOTE: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.