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IRS Rejects Profit-Sharing Health Accounts

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Federal officials are stopping efforts to put tax-exempt medical reimbursement accounts in 401(a) profit-sharing plans.[@@]

Employers can put MRAs in 401(a) plans, but those employers must apply the same distribution rules to MRA distributions and other types of 401(a) distributions, and employees must include the MRA distributions in their taxable gross income, Robert Walsh, an official at the Internal Revenue Service, writes in IRS Revenue Ruling 2005-55.

Section 401(a) of the Internal Revenue Code lets employers cut employees’ current income tax bills by putting income in special personal accounts and helping the employees defer payment of income taxes to a later date.

The 401(a) plan participants normally must pay income taxes on any plan distributions that they receive.

Employers that have set up 401(a) MRA programs also relied on Internal Revenue Code Section 105. Section 105 lets employees exclude direct reimbursement for medical expenses from taxable income.

Other IRS rules let employees use up to 25% of 401(a) account funds to pay for life insurance, accident insurance and health insurance, Walsh writes.

But employers that try to put a tax-exempt MRA inside a 401(a) plan, by limiting use of the MRA funds to paying medical bills, are violating a law that gives 401(a) plan participants an unconditional right to collect the MRA funds, Walsh writes.

If there is any chance that employees enrolled in a 401(a) MRA plan will forfeit some of the MRA funds, that plan “imposes a condition on the entitlement of the participant (and the participant’s beneficiaries) to the amounts held in the medical reimbursement accounts,” Walsh writes. “As a result of that restriction, these amounts fail to be nonforfeitable.”

The IRS has approved the creation of at least 1 401(a) MRA program by issuing its creators a favorable determination letter.

The IRS is shielding existing 401(a) MRA programs that it has approved from some of the effects of the new revenue ruling.

Employers must change the 401(a) plan rules starting with the first day of the first plan year beginning after Aug. 15. But IRS-approved plans that amend their rules will continue to qualify for the tax breaks that are usually available to 401(a) plans, Walsh writes.

Employees can exclude 401(a) MRA distributions from taxable income as long as the distributions are made before the start of the first plan year that begins after Aug. 15, Walsh writes.

A copy of the 401(a) MRA ruling is on the Web at //


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