Proposed regulations from the Internal Revenue Service regarding the providing of added insurance coverage by a defined benefit plan could in fact inhibit the ability or the desire of plans to offer such benefits, according to comment letters from industry participants.

The proposed rule was opened for comment in August and drew the concern of groups such as the Association for Advanced Life Underwriting and the American Benefits Council.

In its comment letter, the AALU raised strong concerns about proposed regulations that it argued would tax any accident or health insurance premiums paid under a qualified retirement plan. Written by AALU President Larry Raymond, the letter called for the proposed regulations to either be withdrawn or be modified to create an exception for disability insurance benefits.

The American Benefits Council also took issue with changes in the handling of disability premiums. “With regard to the proposed regulation, we are concerned that it could affect a wide variety of common practices that our members use to provide and protect the retirement income of disabled employees under qualified plans,” said Lyn Dudley, vice president of retirement policy for the council in its comment letter. Specifically, ABC noted that those practices include the provision for continued defined contribution plan accruals for employees on long-term disability, including those with funding from employer contributions, the purchase of a special LTD policy designed for DC plans, or from a companion welfare benefit trust.

“The Council cannot identify any basis for subjecting these disability protection features to the concepts that Treasury and the Service have developed to address the treatment of health insurance,” Dudley wrote. “We are concerned that this proposed regulatory approach will prevent employers from continuing to maintain or add disability protection features to their qualified plans. Instead, the regulations should be designed to encourage the provision of disability protection in individual account plans through all of the methods in use today.”

The IRS has a rule allowing qualified retirement plans to provide “incidental benefits” in addition to retirement benefits, which provides the basis for providing life insurance under qualified plans and also encompasses accident or health insurance, which includes disability insurance. The amount of insurance premiums that can be paid for all incidental benefits cannot exceed 25% of the aggregate contributions allocated to a participant’s account.

The proposed changes, according to AALU, would not affect the incidental benefits rule itself, nor has it proposed any changes to the taxation of life insurance provided by qualified plans. Instead, it has proposed changes in the tax treatment of accident and health insurance, including disability insurance that is provided under qualified retirement plans.

AALU believes the proposed regulations would change that treatment to require that the purchase of the disability insurance would be considered a distribution to the participant followed by a re-contribution of the deemed distribution to the trust. This new treatment would trigger income tax, could trigger additional taxes and raise testing and qualification issues. “Instead of waiting to tax the participant until any insurance proceeds are actually distributed from the qualified plan, the IRS is proposing to tax the disability insurance at the earlier time when the insurance premiums are paid,” said Raymond.

AALU said the IRS has previously recognized in two private letter rulings that, when a qualified plan purchases LTD insurance and the benefits of that insurance are payable to the trust, neither the payment of the premiums nor the receipt of the proceeds by the trust is a taxable event. Instead, the IRS held that only the ultimate distribution from the plan to the participant would be taxable.

Raymond said AALU “gave this matter considerable thought” and believes its recommendations are “in the best interests of clients and is grounded in sound public policy.” He added that the group is “hopeful” the IRS will pay heed to its comments, but that “prospects of a favorable result are hard to assess.”

Nationwide is asking in its comments for additional guidance from the IRS on certain issues. For example, in detailing with the treatment of voluntary and revocable assignments of benefits Nationwide is asking the IRS to clarify whether an assignment not to exceed 10% of any benefit payment is permissible under Sec. 402(a), including one where assigned back to the same 401(a) plan.

But Nationwide officials say they support a provision in the proposed regulation which clarifies that payments from a qualified plan for an accident or health insurance premium generally constitutes a taxable distribution under Sec. 402(a). However, they said, a separate clarification is needed to identify in a final rule regarding voluntary and revocable assignments of Sec. 401(a) benefits.