Mega 401(h): Combining Tax-Free Medical with Pre & Post Tax Retirement Contributions


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Maybe you have heard about every retirement plan in the book. Maybe not. We learn something new everyday.

In this post, we will discuss one of my favorite retirement structures. It’s called the Mega 401(h). I usually refer to it as the “Mega(h)”.

This strategy alone will not give you the largest contribution. It won’t even be the most flexible.

But if you are looking for large contributions along with tax deductible medical this plan might do the trick. Let’s review the structure.

Basic Structure

The benefits of the Mega(h) is really based on the combination of three specific retirement plans. Combining retirement plans is a somewhat rare concept in the overall retirement space, but it is common with many retirement administrators who work on custom plan designs.

The IRS does not allow many retirement plans to be combined. In fact, many plans are combined with significant restrictions, administrative headaches or simply banned outright.

But if carefully crafted, you can utilize the specialized benefits of each plan to super-size the overall retirement structure.

There are three components to the Mega(h):

  1. Money Purchase Plan
  2. 401(h) Account
  3. 401(k) Plan with After-tax option

Let’s now take a look at each of the three components and then tie them all together into one powerful retirement strategy.

What is a Money Purchase Plan?

It seems everybody has heard of a Money Purchase Plan, but nobody really knows much about them. This is for good reason. They are generally inflexible and for some people a 401k will be just fine.

They don’t really make much sense as a standalone plan. But when combined with other structures, they can be very powerful.

They act mostly like a profit sharing plan. But with a significant downside. The annual contributions are mandatory.

Most profit-sharing plans do not have a mandatory or required contribution. The money purchase pension plan has a required contribution that is outlined in the plan document and can be as high as 25% of compensation.

So why would you want to use this type of plan?

There are a couple good reasons. Money Purchase Plans offer two main benefits:

  1. They are technically a “pension” plan; and
  2. The IRS allows them to be combined with other retirement plans.

The above two benefits cannot be emphasized enough. Without them, this strategy simply won’t work. So let’s take a look at why these benefits are so important.

Why is it considered a pension?

The term “pension” can mean different things to different people. Many people use the term “pension” to refer to retirement plans in general. But the IRS refers to a “pension” as a specific type of retirement structure, such as a cash balance plan or a different kind of defined benefit plan.

A pension plan is generally defined as a qualified retirement plan that is established and maintained by a company to systematically provide for the payment of definitely determinable benefits to its employees. The requirement of benefits being “definitely determinable” may be met by providing either fixed contributions or fixed benefits. As such, a pension plan may actually be a defined contribution plan or a defined benefit plan. 

Money purchase plans are technically defined contribution plans, but they fall under the “pension” plan umbrella. This is because they require annual contributions. 401(k) plans and other profit-sharing plans are not pensions because they do not require specified yearly contributions.

As a general rule, profit-sharing plans and defined benefit plans provide more flexible contributions. But a money purchase plan does have some advantages when combined with a 401(h) account.

The annual contributions to a money purchase plan are fixed (not variable or elective) based on the employee wage. They are not based on the company’s business profit.

What is a 401(h) Account

Many business owners understand what a Health Savings Account (HSA) is. But very few have ever heard of a 401(h) account. Why is so little known about this structure?

The reality is that there is just not a lot of guidance out there on the plans. Many business owners have 401(k) plans or SEPs, which are not actually “pensions” in the eyes of the IRS. So the 401(h) account is not technically available to many business people.

401(h) account specifics

A 401(h) is not an actual “plan” itself. It is a medical expense account that is added on to a pension plan such as a defined benefit pension plan or a money purchase plan. You can see where the IRS specifically states that a 401(h) account can be included with a Money Purchase Plan here.

Section 401(h) of the IRS Code allows a pension plan to provide payment of medical expense benefits for retired employees, including spouses and dependents. There are some specific rules.

A separate plan document must be drafted that permits the business to fund medical expense benefits for the company’s retired employees. Account contributions are tax-deductible along with an account earnings. 

The allowable account is similar to an HSA, but contribution limits can be significantly higher.

401(h) account contribution limits

The account comes with unique contribution limits. There are actually two critical rules to understand:

  1. Contributions are tied to the defined contribution plan rules and limits. This sounds counterintuitive because 401(h) accounts are normally associated with to defined benefit pension plans. But based on section 415(l)(1), contributions made to a 401(h) account are treated as defined contribution plan contributions and fall under the annual funding limitations.
  2. 401(h) account contributions are limited to 25% of the overall pension contributions. This percentage limitation is cumulative. This means that if lower contributions were made in previous years, the owner could actually “catch up” the contributions in the current year to get to the cumulative account cap.

What about the 401(k) plan?

You may already know a lot about 401(k) plans and how they work. They are really starter plans for most small business owners.

The plans come with a deferral (or employee) contribution amount and also an allowable employer contribution. Because these plans are defined contribution plans, they fall under the same annual limitation as the Money Purchase Plan and the 401(h) account.

Since a contribution to a 401(k) plan is elective and not required like a Money Purchase Plan contribution, you can use a 401(k) contribution to get a little more into retirement and get you to the annual cap.

Example

Let’s take a look at an example of contributions for three specific business owners. We will also address the floor and the ceiling in each scenario.

Each scenario assumes an S-Corp owner with no employees other than the owner. Our hypothetical owner is 55 years old and has a Money Purchase Plan contribution requirement of 25% of salary. As of this writing, the annual limitation to a defined contribution for a 55 year old is $67,500.

W2 Amount$40,000$100,000$160,000
Contributions:
Money Purchase$10,000$25,000$40,000
401(h) $3,334 $8,350$13,360
401(k)$26,666$34,150$14,140
TOTAL$40,000$67,500$67,500

Advantages & Disadvantages of the Structure

There are several pros and cons of this structure. Let’s take a look through them.

Pros

  • Because a money purchase plan is not a defined benefit plan, there is no annual requirement for an actuary to review and sign off. This results in generally lower administrative fees and simpler administration.
  • The contribution to the 401(h) account remains elective. While it is capped at 25% of the combined cumulative contributions, you are not required to make annual contributions.

Cons

  • Remember that money purchase plans have required contributions. So the business owner must ensure that they at least have the cash flow to make the required contribution.
  • While combined contributions can be relatively high. They are not as high as contributions that could be made with a defined benefit plan.
Paul Sundin

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