Recently, many of our colleagues have received inquiries about “401(h) plans.” A 401(h) is not a type of plan but rather an ancillary benefit of a defined benefit plan. A 401(h) account provides a highly efficient way to fund retiree health benefits. Contributions to the account are tax-deductible, earnings on the account grow tax-free, and health benefits paid from the account are not taxable to retirees if used on qualified medical expenses. The account can be considered similar to a health savings account with higher limits. But there are limitations that may make it difficult or impossible for an employer to utilize a 401(h) account. This article summarizes the requirements, advantages, and disadvantages of Section 401(h) accounts.
Background
In 1962, Congress added Section 401(h) to the Internal Revenue Code. Subsequent regulation describe the conditions that must be satisfied to preserve the tax-qualified status of a pension plan that includes a 401(h) account and when an employer’s contributions to a 401(h) account are deductible. These regulations have not been revised since they were issued 57 years ago.
Qualification Rules
Section 401(h) provides that, if certain conditions are satisfied, a “pension or annuity plan may provide for the payment of benefits for sickness, accident, hospitalization, and medical expenses of retired employees, their spouses and their dependents.” A 401(h) account can be established as part of any “pension” plan, including both a defined benefit pension plan and/or a money purchase pension plan. The following conditions for establishing a 401(h) account are described in Treas. Reg. §1.401-14.
Specified benefits. The plan must specify the health benefits that will be available and must include provisions for determining the amount that will be paid. The employer’s contributions to the 401(h) account must be “reasonable and ascertainable.” This requirement will not be satisfied unless the terms of the 401(h) plan amendment specify the amount of benefits and the time period with respect to which benefits will be paid. The plan may not allow for employer discretion in the timing and amount of benefit payments from the 401(h) account.
Separate account. A separate account must be maintained for contributions used to fund the health benefits. The separation is for recordkeeping purposes only; the 401(h) funds need not be separately invested. It appears that a 401(h) retiree health account may operate as a pooled reserve that pays health benefits for all covered participants/retirees (similar to a defined benefit plan) or may include separate retiree health accounts to provide health benefits for each participant/retiree under the plan (similar to a defined contribution plan).
Neither the law nor the regulations address how the separate account should be designed.
Contribution limit. The health benefits provided under the plan must be subordinate to the retirement benefits provided under the plan. This “subordination” requirement specifies that the aggregate actual contributions for health benefits under the plan (plus the total contributions for life insurance protection under the plan, if any) must not exceed 25% of the total actual contributions to the plan (other than contributions to fund past service credits) made after the date on which the account is established.
The 25% limit is a cumulative limit based on all employer contributions to the pension plan after the date the 401(h) account is established. Thus, if an employer makes 401(h) contributions for several years that are less than the maximum amount permitted under the 25% limit, the employer may subsequently be able to make 401(h) contributions up to the cumulative limit, even though it may no longer make deductible contributions to the retirement portion of the plan because of §404(o). We are not sure whether past pension contributions may be taken into account unless the 401(h) account was funded with more than “de minimis” contributions.
Key employees. A separate account must be maintained for the health benefits payable to each employee who is (or ever was) a key employee. Contributions to provide retiree health coverage to a key employee must be allocated to the key employee’s separate account and are treated as an annual addition to a defined contribution plan for purposes of the Section 415(c) dollar limit. In addition, retiree health benefits provided to a key employee must be charged against the key employee’s account. When the account is exhausted, the key employee’s retiree health benefits may no longer be provided under the 401(h) account.
Vesting. Contributions to a 401(h) account are not subject to the minimum vesting requirements that apply to pension contributions.
Nondiscrimination requirements. The health benefits funded by a 401(h) account must not discriminate in favor of highly compensated employees with respect to coverage and contributions or benefits under the plan. The regulations under Section 401(h) do not provide any guidance about how this test is applied. Presumably the test will be satisfied as long as retiree health benefits are available to a nondiscriminatory group, and highly compensated retirees are not entitled to a disproportionate share of the benefits.
Deduction Rules
An employer’s contributions to a 401(h) account are deductible, subject to certain conditions and limitations. Employer contributions may not exceed the total cost of providing the 401(h) health benefits. Under the regulations, the “total cost” of the health benefits must be determined in accordance with a generally accepted actuarial method that is reasonable in view of the provisions and health coverage provided under the 401(h) portion of the plan.
The amount deductible for a year may not exceed the greater of two amounts:
- the amount determined, either as a level amount or as a level percentage of compensation, by spreading the remaining unfunded costs of past and current service credits over the remaining future service of each employee, or
- 10% of the cost which would be required to completely fund or purchase the health benefits. This amount also can be determined using a 10-year amortization schedule (including interest).
Contributions to a 401(h) account are not subject to Code Section 404(a)(7). Since they are part of the contribution to the defined benefit plan, this provides an opportunity to deduct more than what Section 404(a)(7) would otherwise limit.
Advantages of a 401(h) Account
Tax-free health benefits. Retiree health benefits provided through a 401(h) account are tax- free to retirees and their beneficiaries. The principal requirement is that the plan must provide health benefits only.
No minimum contribution. An employer is not required to make 401(h) contributions for a year, even though a contribution could otherwise be made and deducted under the limits described above. Thus, for example, an employer may choose to contribute any amount to a 401(h) account for a year up to the maximum permitted contribution under the 25% limit.
Section 420 transfers to a 401(h) account. A 401(h) account may be used in a Code Section 420 transfer. Excess assets from a terminating defined benefit pension plan may transfer to a 401(h) account. An employer may make such a transfer if several requirements are satisfied.
Disadvantages of a 401(h) Account
Individually Designed Document. Retiree health benefits provided through a 401(h) account are not approved under Master and Prototype or Volume Submitter plans.
Longevity of the Plan. A plan that may have otherwise terminated with key employees reaching retirement age need to maintain the retirement plan until post-retiree medical accounts are exhausted to fully take advantage of the tax benefit.
Health Valuation of the Benefits. Most retirement plan providers are not also health actuaries. Hiring an independent health actuary to value the post-retirement medical benefits adds cost to plan administration.
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