Pros and Cons of 401(h) Accounts: The Simple Guide [2022 Update]

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A big part of retirement costs is healthcare expenses. Many people don’t realize how much their healthcare expenses will increase whether due to a more frequent need for healthcare or because of the co-pays and co-insurance amounts due with Medicare.

Your employer may be able to offer a 401(h) account in addition to a defined benefit plan (pension), which is similar to an HSA (Health Savings Account), but for use only during retirement.

This tool can be helpful for high-earning employees or self-employed individuals to not only provide financial support for healthcare during retirement but also to provide tax benefits now.

What are 401(h) Accounts?

A 401(h) account is a way for employers to help employees with their healthcare costs in retirement. Like a 401(k), the 401(h) is money set aside for use when you retire. Like a 401(k), the contributions are tax deductible, and the earnings grow tax-free too. If you use the money for qualified medical expenses, your withdrawals are also tax-free.

Employers can contribute to this separate account alongside a pension plan to help employees during retirement. The funds contributed to the 401(h) account are used to cover medical expenses that insurance doesn’t cover. The account remains in existence until the retiree uses the funds up.

How do they Work?

The 401(h) account is meant to help you with costs during retirement that Medicare or any other insurance plan doesn’t cover. You can use it to pay copays, out of pocket expenses, insurance premiums, and long-term care costs.

The plan can only be offered by your employer, and he/she isn’t obligated to contribute to it every year. You are only eligible for benefits when you retire or are considered disabled and unable to work – you cannot use the healthcare benefits while you’re still working.

Understanding Rules

Like most benefit plans, there are rules regarding how much an employer can contribute. But unlike other retirement plans, the rules are a bit trickier.

Under the plan, employers cannot contribute more than 25% of the amount contributed for an employee’s retirement. But if an employer didn’t contribute to an employee’s 401(h) every year and hasn’t reached the 25% limit, the employer can make up the contributions to reach the 25% limit for the employee.

The 401(h) plan doesn’t have vesting requirements, which means you don’t have to be working at the company for a certain amount of time to use the benefits in retirement.

The Advantages of 401(h) Accounts

Like all benefit plans, an employer can offer employees, there are advantages and disadvantages to consider.

Here are the advantages of the 401(h) plan:

  • Employers can deduct the contributions on their tax returns up to a point. The money contributed can’t exceed the total cost of the benefits.
  • Retirees earn the benefit tax-free. The money grows tax-free and as long as you use the money for qualified medical expenses, the withdrawals are tax-free too.
  • Employers can contribute as little or as much (up to the 25% limit) as they want per year. They aren’t required to make contributions, but they can if they choose to do so
  • The money can cover any dependents’ medical care too including spouses or dependent children.

The Disadvantages of 401(h) Accounts

There are also some disadvantages everyone should consider before choosing the 401(h) account:

  • The plan itself is complicated and requires expensive set up and administration fees. It’s not an IRS pre-approved plan which means it takes more time, administration, and supervision to run the account.
  • Employers must keep the account active until all employees use up their benefits in the medical account during retirement.
  • It can be hard to find the personnel to manage and oversee the account, as actuaries are often required for this task.

Final Thoughts

A 401(h) plan is an add-on to a defined benefit plan and can be a great way to provide employees with financial assistance with healthcare costs during retirement. It has higher limits than a Health Savings Account and provides both the employer and employee with tax benefits during its lifetime.

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