When Are 401(h) Contributions Limited Under Code Section 415?

A 401(h) plan is a supplemental account, typically tied to a defined benefit pension plan, designed to provide tax-advantaged funding for retiree healthcare benefits. These plans allow employers to pre-fund healthcare expenses for their retirees, offering a significant advantage for both the company and its employees.

The unique structure of a 401(h) plan allows contributions to grow tax-deferred, and distributions for qualified medical expenses are tax-free. This makes them a powerful tool in a comprehensive retirement and benefits strategy, especially for small business owners and high-income earners looking for creative ways to manage future healthcare costs.

While 401(h) plans offer attractive benefits, contributions are not unlimited. The Internal Revenue Service (IRS) imposes restrictions to ensure these plans are used as intended and do not become an excessive tax shelter. A primary regulation affecting 401(h) contributions is IRS Code Section 415.

Section 415 generally sets limits on contributions and benefits in qualified retirement plans, including defined benefit and defined contribution plans. For 401(h) plans, this section plays a critical role in determining how much can be contributed, particularly concerning highly compensated employees.

One of the key aspects of 401(h) plans, as outlined by Section 415, is how contributions for Highly Compensated Employees (HCEs) are limited. An HCE is generally defined by the IRS as an employee who meets certain compensation thresholds or ownership criteria. For these individuals, 401(h) contributions are specifically capped.

The relevant language in the regulations states that for HCEs, the amount allocated to their 401(h) account is treated as an "annual addition" to a defined contribution plan for the purpose of applying the Section 415(c) limits. This means their 401(h) contributions, when combined with contributions to any other defined contribution plans they participate in (like a 401(k)), cannot exceed the annual limits set for defined contribution plans.

Beyond the Section 415 limitations, 401(h) plans also operate under the 'incidental benefit' rule. This rule ensures that the primary purpose of the main pension plan remains retirement income, with the healthcare benefits being a supplemental, or 'incidental,' feature.

Generally, the aggregate contributions made to the 401(h) account cannot exceed 25% of the aggregate employer contributions made to the related defined benefit pension plan (excluding contributions for past service cost). This rule acts as an additional guardrail, preventing the healthcare component from overshadowing the core pension benefit.

Navigating the rules surrounding 401(h) plans and Section 415 requires careful attention to detail. Plan sponsors must ensure that all contributions, especially those for HCEs, remain within the prescribed limits to avoid disqualification of the plan and potential tax penalties.

• Regular Review: Periodically review your plan's contribution structure and participant demographics to ensure ongoing compliance.
• Professional Guidance: Consult with experienced actuarial and legal professionals to accurately interpret and apply IRS regulations to your specific plan.
• Employee Communication: Clearly communicate the benefits and limitations of the 401(h) plan to all participants, particularly HCEs, to manage expectations and ensure understanding.