3945 / Is an employee generally taxed on the employer’s current contributions to a qualified plan?

No, unless the contributions are designated Roth contributions under a 401(k) plan.

A participant does not have to include contributions made by the employer in gross income when the participant’s rights in the plan become fully vested or when benefits can be paid, if elected by the participant (i.e., if the benefits are constructively received). Rather, there is no taxation until benefits actually are distributed to a participant. Delaying distribution will postpone taxation unless it is delayed too long and minimum distribution requirements are not met ( Q 3891 to Q 3909).¹

Another exception to the general rule that employer contributions are not taxable when contributed is when the plan uses some of those contributions to purchase life insurance on the participant that is payable to a beneficiary of the participant. Basically, the participant reports as income the cost of the pure death benefit under the contract. This cost is determined based on a table referred to as Table 2001. For the method of determining the “cost” of such insurance protection taxable to the employee, see Q 3948.

Effective January 1, 2015, premiums paid by a pension, profit sharing trust, stock bonus plan, 401(h) plan, pension plan, or annuity plan on accident or health insurance for an employee are currently taxable to the employee as distributions from the trust.² Final regulations effective May 12, 2014 clarify that amounts used to pay accident or health insurance premiums (but not disability insurance that replaces contributions) are taxable distributions, with some exceptions, regardless of whether the employer pays the premium from a current year contribution or forfeitures.³ Thus, if a trustee of a qualified trust uses employer contributions or trust earnings to purchase insurance to provide postretirement medical benefits in an IRC Section 401(h) account or to pay accident or medical benefits, the amounts applied are not taxable income to the employee for whom the insurance is purchased.⁴

In contrast, a direct distribution from a pension, profit sharing trust, stock bonus plan, 401(h) plan, pension plan, or annuity plan to reimburse an employee for medical expenses is not a taxable distribution to the employee.⁵

Regulations also clarify that with respect to pension, annuity, profit sharing and stock bonus plans, the payment of disability premiums for insurance that replaces retirement contributions are not distributions.⁶

Where a governmental employer “picks up” plan contributions otherwise designated as employee contributions, the contributions are treated as employer contributions.⁷ These contributions are excluded from the employee’s income and are not subject to withholding.⁸ A state law authorizing various retirement systems to “pick up” contributions is not sufficient to effectuate a “pick up” of employee contributions.⁹ A governmental employer must specify that contributions designated as employee contributions are being paid by the employer in lieu of employee contributions, and the employee must not have the option of choosing to receive the contribution directly.¹⁰ The required specification of payment of designated employee contributions by the employer must be completed before the period to which the contributions relate; retroactive “pick up” is not permitted.¹¹ An employer may “pick up” either pre-tax or after-tax contributions used to repurchase service credit.¹²

Where a governmental employer’s plan explicitly stated that mandatory employee contributions, although designated as the participants’ contributions, would be “picked up” by the employer and treated as employer contributions, those contributions were excluded from the employee’s income until the time that they were distributed. Further, the contributions were excluded from wages for income tax withholding purposes. Importantly, the IRS noted that the plan did not give the plan participant the right to choose cash or a deferred election right with respect to the picked up contributions.¹³