The 25% Subordination Test for 401(h) Funding

A 401(h) plan is a special account linked to a defined benefit pension plan, designed to help retirees cover healthcare expenses. It offers a unique way for employers to provide tax-advantaged healthcare benefits alongside traditional pension income. Contributions to a 401(h) are tax-deductible for the employer, and distributions for qualified medical expenses are tax-free for the retiree.

The fundamental principle behind 401(h) plans is that the healthcare benefits provided must always be subordinate to the primary retirement benefits. In simpler terms, the money set aside for healthcare expenses should not overshadow the money set aside for regular pension payments. This ensures the integrity of the defined benefit plan as a retirement income vehicle first and foremost.

The 25% subordination test is a critical rule that governs how much an employer can contribute to a 401(h) account. It dictates that the aggregate amount contributed to a 401(h) for retiree medical benefits, when added to amounts for life insurance protection, cannot exceed 25% of the total aggregate contributions made to the defined benefit plan since the 401(h) account was established. This isn't a per-year limit, but rather a cumulative test over the life of the plan.

Meeting this test is paramount for maintaining the tax-qualified status of both the 401(h) and the larger defined benefit plan. Failing the 25% subordination test can have significant tax consequences, including the potential disqualification of the plan.

While often discussed alongside the subordination test, the '33% funding rule' addresses a separate, though related, aspect of 401(h) funding. This rule primarily applies to the transfer of excess assets from a defined benefit plan to a 401(h) account. If a defined benefit plan is overfunded, a portion of those excess assets (up to 33% of the amount transferred to the 401(h) in certain situations, or 33% of the total plan contribution in others) can potentially be used to fund the 401(h) account, provided other conditions are met. This rule often pertains to specific instances of asset reallocation rather than ongoing contributions.

Navigating the 25% subordination test and other related funding rules requires careful planning and a deep understanding of your defined benefit plan structure. For small business owners, doctors, and high-income earners, strategically utilizing a 401(h) can create a substantial tax-advantaged pool for future healthcare costs, especially as healthcare expenses continue to rise in retirement.

Working with experienced professionals, such as actuaries and tax advisors, is crucial. They can help you project funding limits accurately, ensure compliance with IRS regulations, and optimize your contributions to secure significant future tax-free benefits.