What to Know about the 401(h) Plan

Rocco Beatrice is a CPA, MBA, MST with Estate Street Partners, a team of lawyers, accountants and business strategists that, combined with our actuarial partners, have helped more than 5,000 doctors, 1099 employees and business owners work with their own CPA’s in order to take advantage of these tax-altering pension, Super 401(k) and 401(h) plans over our 30+ years in business. 

The most exciting changes that came along with the Pension Protection Act were also, shockingly, one of the least discussed sections of the Internal Revenue Code: the changes to the 401(h).

Section 401(h) of the IRC provides for specific accounts to be created for the purpose of paying for medical-related expenses during retirement.

Similar to the 401(k), the IRS classifies the 401(h) as a cafeteria plan, which means it is intended to be managed by employers for the benefit of employees. Unlike the 401(k), however, the 401(h) is not a plan that is perfect for everyone. 

The amazing fact is that 98% of the most qualified individuals for these plans never take advantage of them, primarily because they, nor their CPA, have never heard of them. 

The cost to implement and maintain these plans is far outweighed by the benefits these plans offer, which can potentially lead to  some of the best ROI in the IRS tax code.  Ask your CPA about a 401(h).

How the 401(h) Plan Works

In essence, the 401(h) is a medical expense account attached to a Cash Balance Plan account that aims to alleviate the financial burden of health conditions, accidents and hospitalizations that individuals and their dependents may come across in their retirement.

As with other plans, a 401(h) account must be separately funded and managed. As the plan is being funded, the contributions made are tax deductible.

The money is allowed to grow capital gains, tax-free. When funds are later withdrawn in retirement, the money that comes out of a 401(h) plan is also tax free.

In other words:

1. 401(h) plans can be funded with tax-deductible money.
2. Funds deposited into 401(h) plans are allowed to grow without the burden of taxation.
3. Funds withdrawn by 401(h) account beneficiaries once they retire are not taxed.

To some extent, 401(h) plans are similar to voluntary employee beneficiary associations, which are better known as 501(c) plans, in the sense that they are designed to provide retirees financial cushions for health expenses and life insurance. In fact, 501(c) plans can be combined with 401(h) plans.

Unlike the Roth Individual Retirement Arrangement or certain insurance-based instruments such as annuities, a 401(h) plan can actually provide a fully tax-free solution for retirement.

A business owner who takes Cash Balance Plan account and deposits them into a 401(h) account is essentially shielding those funds from taxation forever. This is one of the very few IRC provisions that provide a completely tax-free environment, and it is an opportunity that is certainly worth exploring by individuals who are interested in asset protection and wealth preservation strategies.

The Rationale of 401(h) Plans

Even after the insurance reform of the Affordable Care Act, healthcare inflation has not stopped. In 2014, the inflation rate of medical care in the United States increased by a little more than 3.5 percent, which is about 400 percent higher than the consumer price index.

By the end of this decade, retirees can expect that the costs of their medical expenses could climb between five and seven percent annually.

AARP cites Fidelity Investments which estimates “that a 65-year-old couple retiring [in 2013] will need $240,000 to cover future medical costs. That doesn't include the high cost of long-term care. Nor does it take into account additional costs you may incur if you decide to take — or are forced into — early retirement before your Medicare kicks in.”  Doctors who celebrate their 55th birthdays today can expect their medical care costs to be nearly $465K when they retire with their spouses in the next 10 years.

Supplemental insurance policies combined with Medicare plans are not sufficient to cover all medical expenses that business-owners and other professionals are bound to face during their retirements.

Most often, retirees dip into their savings or tap into their taxable retirement income to pay for out-of-pocket medical expenses. These are the situations that 401(h) plans seek to alleviate. 

When a business-owner who decides to participate in a 401(h) plan for the benefit of his staff, he or she must establish the contributions amounts, which must be reasonable, under Treasury Regulation 1.401-14(c)(3).

This is related to the aforementioned estimate of healthcare costs and their inflation; in other words, a 401(h) plan can accumulate up to $460K in contributions that can be grown through investments and later withdrawn without any taxation.

Furthermore, the IRC can be amended in the future to allow greater contribution limits to match the rising inflation of medical expenses.

Another advantage of 401(h) plans is that the list of qualified benefits is very extensive. A few treatments that are typically excluded from health insurance policies are allowed by 401(h) plans.

Some of these include:

• elective cosmetic surgery procedures
• spa and fitness programs
• Lasik eye surgery
• designer eyeglass frames. (See a more extensive list here.)

The Practicality of 401(h) Funds

401(h) plans give business-owners the ability to fund part of their retirement with deductible money so they can later enjoy tax-free distributions to cover a broad range of medically-related expenses.

This is money that can truly come out 100 percent tax-free when business-owners, 1099 employees and doctor-owners retire.

Let's say Dr. Elsa Parks, a 55-year old general practitioner, runs a family medicine practice that employs two medical assistants and a licensed practical nurse. She is married and has an average income of $700,000 per year.

Living in California, she pays federal income taxes at 39.6% and state income tax at a rate of 11%, for a total of 50.1%.  This does not include FICA or self-employment taxes.

As a small business owner, Dr. Parks can use the existing corporate structure of her practice to establish a Cash Balance Plan and medical expense account under section 401(h) of the IRC.

Even if Dr. Parks worked only as a self-employed on-call physician, she could actually get some advice on how to form a business entity in her state for the purpose of setting up a Cash Balance Plan and 401(h).

Being 55 years old, married and having income of $700,000 per year gives her the ability to fund her Cash Balance and 401(h) by up to $670,000 per year. She has chosen to contribute $600,000 to her Cash Balance and 401(h) plan. Effectively, she has reduced her quarterly income tax check by $64,500.

The bottom line of 401(h) plans is that Americans are living longer and seeing their healthcare costs rise every year.

With so many retirement plans subject to taxable distributions, the 401(h) is one of the top options for business owners, 1099 employees and doctors who would like to cover their out-of-pocket medical expenses without the burden of taxation.