401(h) Accounts: The Complete Guide to Tax Free Medical


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Many people have heard of a 401(k), but few have heard of a 401(h). This post will discuss one of the best-kept secrets in medical expense plans: the 401(h) account.

But understanding how the accounts work can be complex. There are just not many administrators or providers in the marketplace.

So, what is a medical expense account under Code Section 401(h)? How do 401(h) plans work? In this post, we will take a close look at how it works.

What is a 401(h) account?

A 401(h) is not a separate plan but an “add-on” to a defined benefit plan. A 401(h) account is an efficient and effective way for a company to fund health benefits to retired employees. 

Specified contributions to the account are tax-deductible. Also, earnings in the account grow tax-free. Medical benefits paid are not taxable to the retiree as long as the expenses are qualified medical expenses. 

A 401(h) is similar to a Health Savings Account (HSA), but they have higher contribution limits. However, there are some challenges that employers face when establishing a 401(h) account. 

Under Code Section 401(h), the term retired means that the employee has met eligibility to receive benefits under the plan or the employee is considered retired due to permanent disability. 401(h) benefits are only available if the employee retires from the company. No 401(h) benefits are available before retirement.

What are the 401(h) medical benefits?

401(h) benefits are made to reimburse post-retirement medical expenses that are not covered by insurance or Medicare. This includes insurance premiums, prescriptions, co-pays, dental costs, and long-term care as defined by the 401h administrators.

The plan will specifically identify the medical benefits available and include written provisions for determining the amount paid. The company’s designated contributions to the 401(h) account must be “reasonable and ascertainable.” The 401(h) plan will specify the benefit amounts and the time frame in which the benefits will be paid.

A separate account is required to be maintained for all contributions used to fund medical benefits. The separate account is solely for record-keeping purposes and does not need to be separately invested. 

plan document s-corp with spouse

A 401(h) account can operate as a pooled account. This account will pay health and medical benefits for all eligible retirees. In this approach, it is very similar in operation to the corresponding defined benefit plan. It also could maintain separate accounts to provide medical benefits for each retiree, much like a defined contribution plan).

The code section does not address how the separate account should be designed. But most administrators have a process.

The 25% limit

The medical benefits must be subordinate to the retirement benefits provided under the plan. This “subordination” requirement is somewhat complex. The aggregate contributions for medical benefits cannot exceed 25% of the total contributions to the plan made.

The 25% limit is a cumulative limit that is based on all company contributions to the plan after the 401(h) account is established. Suppose an employer makes 401(h) contributions for several years less than the maximum amount permitted under the 25% limit.

s-corp plan Medical Reimbursement

In that case, the employer may subsequently make 401(h) contributions up to the cumulative limit. These contributions can be made even though the company may no longer be able to make deductible contributions to the pension portion of the plan. 

A separate account is maintained for medical benefits payable to each employee who is a key employee. Contributions to provide retiree medical coverage for a key employee will be allocated to the employee’s separate account. They are an annual addition to a defined contribution plan for the Section 415(c) dollar limit.

Also, retiree medical benefits paid are charged against that employee’s account. Once the account is depleted, the employee’s retiree medical benefits may no longer be provided.

Vesting is different for 401(h) accounts. Contributions to the 401(h) account are not subject to the minimum vesting requirements applicable to defined benefit plan contributions.

The medical benefits under a 401(h) account cannot discriminate in favor of highly compensated employees. The account will need to pass coverage and contribution testing. 

The 401(h) regulations do not provide much guidance or instruction about how testing is applied. In theory, the test will pass as long as retiree medical benefits are contributed to a nondiscriminatory employee class, and highly compensated retirees do not receive a disproportionate benefit allocation. 

Tax deduction rules for a 401(h) account

A company’s contributions to a 401(h) account are tax-deductible (subject to certain limitations). Employer contributions cannot exceed the total cost of providing the 401(h) medical benefits. 401h administrators will calculate this for you.

An actuary must determine the benefit calculation in accordance with a generally accepted method. This calculation must be reasonable in light of the medical coverage provided under the 401(h) portion of the plan.

The amount deductible for a given tax year cannot exceed the greater of the two amounts below:

  • The amount is determined by spreading the remaining unfunded costs of past and current service credits over the remaining future service of each employee. This can be either as a flat amount or as an equal compensation percentage, or
  • 10% of the cost that would be required to completely fund the health benefits. This amount can also be determined using a 10-year amortization schedule.

Contributions to a 401(h) account are not subject to Code Section 404(a)(7). Since they contribute to the defined benefit plan, this provides an opportunity to deduct more than what Section 404(a)(7) would otherwise limit.

Pros and cons of 401(h) accounts

Advantages of a 401(h) Account

Tax-free benefits. Retiree medical benefits are tax-free to retirees, and contributions are tax-deductible by the company. The main requirement is that the plan can only provide health and medical benefits.

No required contribution. The company is not required to make annual 401(h) contributions, even though a contribution could be made and deducted under the plan limits. As such, the company can choose to contribute any desired amount to the 401(h) account for a given year as long as it does not exceed the maximum permitted contribution (the 25% limit).

Account transfers. A 401(h) account can be used in what is called a Code Section 420 transfer. Excess funds from a terminating defined benefit plan can transfer to a 401(h) account (upon satisfying certain conditions).

Looking for more information on cash balance plans? Take a look at our ultimate guide to cash balance plans. Discover our favorite strategies!

Disadvantages of a 401(h) Account

Custom plan document. Retiree medical benefits through a 401(h) account are not offered through IRS pre-approved plans. The plan must be a custom drafted plan which can result in higher setup costs and annual administration fees. In fact, it can be challenging to locate 401(h) administrators and providers.

Plan longevity. A plan that may have otherwise terminated because key employees reached retirement age will need to maintain the retirement plan until post-retiree medical accounts are zeroed out to benefit from the tax benefit fully tax benefit.

Benefit valuation concerns. The majority of 401h administrators are not healthcare actuaries. Locating an experienced health actuary to value the post-retirement medical benefits adds cost to plan administration.

The plan is not allowed to use designated 401(h) funds for any purpose other than to provide medical benefits under the plan. 

Forfeiture. The plan states that if an individual’s interest in the account is forfeited before plan termination, an amount equal to the forfeiture amount will be applied to lower company contributions to the 401(h) account. 

ProsCons
Tax-Free MedicalHigh Complexity
Optional ContributionsMust be Tied to Pension
Flexible FundingRequired Filing Form 5500
Simple AdministrationAdministrative Costs

401(h) Providers & Administrators

401h administrators are hard to come by. In fact, there are very few providers in the marketplace.

A 401(h) plan is a medical expense account held within a defined benefit plan. It is to be used to pay certain qualified medical expenses of retired employees and certain dependents. 

Paul Sundin

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