Understanding the 401(h) Deduction Limit for Money Purchase Plans

A 401(h) plan is a special account established as part of a defined benefit pension plan or money purchase plan, designed specifically to provide medical benefits for retired employees, their spouses, and dependents.

Unlike an individual health savings account (HSA), a 401(h) is a group-benefit trust. It allows employers to pre-fund retiree healthcare costs on a tax-advantaged basis, offering a valuable benefit in an era of rising medical expenses. It ensures that healthcare coverage can continue into retirement, providing peace of mind for both employers and employees.

To be eligible, a 401(h) account cannot stand alone. It must be incidental to a qualified pension plan. This means it must be offered in conjunction with a primary retirement plan, such as a defined benefit plan or, as in our focus today, a money purchase pension plan.

A money purchase plan is a type of defined contribution plan where employers contribute a fixed percentage of an employee's compensation each year. When paired with a 401(h), a portion of those contributions can be directed towards funding retiree health benefits, offering a powerful dual-purpose benefit structure.

The ability to deduct contributions to a 401(h) plan is a significant tax advantage for employers. However, these deductions are not unlimited. The deduction limit is tied directly to the contributions made to the primary pension plan it accompanies.

Generally, the amount an employer can deduct for contributions to a 401(h) account is limited to 25% of the amount contributed to the primary pension plan (e.g., the money purchase plan) for the year. This specific linkage is critical for compliance and maximizing your tax benefits.

When a 401(h) is joined with a money purchase plan, the deduction limit often operates in conjunction with the overall deduction limits for the pension plan itself.

Here’s a simplified breakdown:

• Total Contributions: All contributions (to the money purchase plan and the 401(h) combined) are generally subject to a broader overall deduction limit for qualified plans.
• 401(h) Specific Limit: Within that overall limit, the contributions allocated to the 401(h) account cannot exceed 25% of the contributions made to the money purchase plan itself.
• Example: If an employer contributes $100,000 to a money purchase plan in a given year, the maximum deductible amount for the 401(h) in that same year would typically be $25,000.

It's important to note that contributions that exceed this 25% limit in any given year cannot be deducted for that year. However, they may be carried forward and deducted in future years, subject to future deduction limits.

Proper plan design is paramount when integrating a 401(h) with a money purchase plan. Working with experienced plan administrators and actuaries can help ensure your contributions comply with all IRS regulations and optimize your tax deductions.

Key considerations include:

• Contribution Strategy: Balancing contributions between the pension component and the 401(h) to remain within the 25% allocation rule.
• Actuarial Soundness: For defined benefit plans with 401(h)s (though not money purchase), ensuring the plan is actuarially sound.
• Documentation: Meticulous record-keeping is essential to justify deductions in case of an audit.

As the cost of healthcare continues to rise, innovative solutions for funding retiree medical benefits, like the 401(h) plan, will become increasingly vital. For small business owners, doctors, and high-income earners, integrating a 401(h) with a money purchase or defined benefit plan offers a sophisticated strategy to provide robust benefits while enjoying significant tax advantages.

Staying informed about regulatory changes and proactively reviewing your plan's structure will ensure it continues to serve your employees' needs and your financial goals effectively into the future.