What is a 401(h) plan?

It’s a medical expense account under Code Section 401(h). The plan pays for costs associated with sickness, accident, hospitalization, and medical expenses of retired employees (EEs), and their spouses and dependents.

One of the largest expenses of retired EEs is their healthcare costs. How do retired EEs pay for such costs? Typically with savings or out of their taxable income. However, with a 401(h) plan, an employer can take a 100% deduction to fund a tax-free sinking fund where when retired EEs remove money from the plan to pay for medical expenses, there are NO income taxes due.

Is a 401(h) plan practical?

Absolutely…here is an example of just how practical they can be:

Example: Assume Dr. Smith earns $400,000 a year (W-2) and has five employees of various ages and salaries. Dr. Smith has been funding in a tax-deferred manner $80,000 into a defined benefit plan every year. If he keeps doing this, he will ultimately have approximately $2 million+ in the plan when he turns 65-years old. Assume that on average Dr. Smith will have $10,000 of medical expenses every year in retirement. Assume he is now and will be in the 35% income tax bracket.

How can a 401(h) plan help?

Dr. Smith could have his medical practice fund X amount of money in a tax-deductible manner into a 401(h) plan every year as an employee benefit for himself and the other employees (discrimination testing for EE contributions is done using the classic age, years of service, and salary testing guidelines).

As stated, the money is allowed to grow tax-free and can then come out tax-free from the 401(h) plan if used for medical expenses (including elective surgery). Therefore, instead of funding $80,000 every year into a defined benefit plan, let’s assume he allocates $10,000 of the $80,000 to the 401(h) plan from ages 55-65.

At age 65, what is the net positive benefit of using the plan?

If I assumed a 5% rate of return in the 401(h) plan and the pension plan, the accounts would both have the same balances when Dr. Smith hits age 65: $149,171 (I’m just comparing the $10,000 contribution made from ages 55-65).

Now let’s assume that Dr. Smith incurs $10,000 of medical expenses every year in retirement. When Dr. Smith uses $10,000 from his 401(h) plan, the money comes out 100% tax-free. When he removes it from the normally defined benefit plan to pay expenses, it is 100% taxable.

How do the numbers compare?

Therefore, the net positive benefit to Dr. Smith when allocating $10,000 to a 401(h) plan vs. a tax-deferred plan is $127,007. This is how much more after-tax money could be removed over time using the 401(h) plan in the above example.

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