IRS Issues Positive PLR On Disability Coverage in 401(k)

The Internal Revenue Service has once again issued a positive private ruling for a group disability product inside a 401(k) plan. The ruling gives more details than a similar one promulgated over two years ago, which allowed the company to market a benefit designed to replace 401(k) contributions for disabled employees.

The earlier ruling (about two years ago) was lauded by commentators as an ingenious idea. But the new ruling helps more by filling in additional information on how the design avoids various IRC pitfalls.

The IRS determined that the arrangement would not violate:

(a) The “incidental benefit” rule, which limits profit sharing plans to providing no more than “incidental” life, accident or health insurance to any participant;

(b) The “contingent benefit” rule, which states that no benefit other than matching contributions can be contingent on the employee making elective deferrals under the plan; or

(c) The “exclusive benefit rule,” which requires that the plan funds and income be used for the exclusive benefit of employees (or former employees) and their beneficiaries.

The IRS also determined that the limits under the Code on compensation, annual additions and elective deferrals, would be applied only at the time the premiums for the benefit were paid, not at a future time when benefits might be allocated to the disabled participants account under the plan.

The conclusions with respect to the taxation of participants were also positive. The Service ruled that:

(i) Premiums would be considered employer-provided coverage under an accident and health plan, excludable under IRC Section 106;

(ii) The payment of premiums would not be considered an assignment of income (which would have led to immediate taxation of the participant);

(iii) Benefit payments to a disabled participants account will be tax deferred following allocation (rather than includable in gross income); and

(iv) Distributions will be subject to taxation under IRC Sections 72 and 402. All of these conclusions were based on the assumption that benefits transferred to the 401(k) plan while the disability benefit is being paid may not be withdrawn by the participant prior to reaching normal retirement age.

The outcome of this ruling should be new opportunities to protect the 401(k) contributions of participants who become disabled, thus helping assure them a retirement nest egg. It may also help plan sponsors increase participation, which is a win-win result for all. (The number of this ruling is Let. Rul. 200235043.)

April K. Caudill, J.D., CLU, ChFC, is managing editor of Tax Facts and ASRS, publications of The National Underwriter Company.


Reproduced from National Underwriter Life & Health/Financial Services Edition, January 13, 2003. Copyright 2003 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.