401(h) Disadvantages: Beware of the Downsides!

A 401(h) plan is a special medical benefit account linked to a defined benefit pension plan. It allows employers to set aside pre-tax contributions to help cover the future healthcare costs of retirees, making it a valuable tool for comprehensive retirement planning.

While offering significant tax advantages and helping employees prepare for what can be substantial medical expenses in retirement, it's crucial to understand that these plans come with specific rules and, as we'll explore, certain limitations.

A §401(h) account can be one of the most tax-efficient ways to pre-fund retiree medical benefits. Contributions are deductible, earnings grow tax-free, and qualified distributions for medical care come out tax-free — a rare triple tax advantage.

But the structure carries real constraints that make it unsuitable for many employers. Understanding the disadvantages is essential before layering a 401(h) onto a retirement plan.

The most significant funding limitation is the subordination requirement. Medical benefits must remain incidental, or subordinate, to the plan's retirement benefits. In practice, the IRS enforces this through the 25% test: aggregate contributions for medical benefits cannot exceed 25% of the total contributions made to the plan after the 401(h) feature is added, excluding contributions to fund past service liabilities.

This caps the amount that can be sheltered in the medical account and ties its funding capacity directly to the size of ongoing pension contributions. A plan with modest retirement contributions simply cannot push much into the 401(h).

Employees do not hold a vested, individually owned interest in 401(h) funds the way they would with an HSA. The benefit is contingent on the plan continuing and on the employee actually reaching retirement and incurring qualifying expenses.

If the plan terminates or the arrangement is unwound, participants may realize little. Forfeitures cannot be used to increase anyone's benefits; they must reduce future employer contributions. This makes the 401(h) a poor tool wherever employee retention or portable, employee-owned benefits are the objective.

Money in a 401(h) account can be used only for the sickness, accident, hospitalization, and medical expenses of retired employees, their spouses, and their dependents. There is no flexibility to repurpose the funds. Worse, the non-diversion rule requires that it be impossible for the assets to be used for any purpose other than these medical benefits before all plan liabilities are satisfied.

Amounts that later revert to the employer are subject to the excise tax on reversions under §4980, plus ordinary income tax. Over-funding therefore creates a genuine trap: contribute too much, and the excess can be effectively stranded or heavily penalized on the way out.

A 401(h) account is not a freestanding vehicle. It must be embedded in a qualified defined benefit or money purchase pension plan. It cannot attach to a profit-sharing or 401(k) plan.

That means an employer who wants the medical benefit must sponsor — and maintain — a pension plan, with all of the attendant actuarial valuations, Form 5500 filings, and (for defined benefit plans) potential PBGC exposure and minimum funding obligations. For a business that has no independent reason to run a pension plan, the overhead of the host plan often outweighs the benefit of the medical feature bolted onto it.

The biggest structural weakness of a 401(h) account is that the money can only ever be used for one thing: qualified medical benefits for retirees, their spouses, and dependents. Section 401(h)(5) requires the plan to state that amounts in the medical account can't be used for any other purpose, and that restriction survives for the life of the plan.

Unlike a 401(k) balance that a participant can roll over, cash out, or leave to heirs, a 401(h) account has no exit ramp. If the covered retirees die early, stay unusually healthy, or simply don't incur enough medical expenses to burn through the account, the money doesn't convert into something else useful. It just sits there, earmarked for a purpose that may never fully materialize.

The problem gets expensive when the plan terminates. Section 401(h)(6) requires that any amounts remaining in the medical account after all liabilities are satisfied must revert to the employer. That reversion is not a friendly outcome: the returned funds are taxable income to the employer, and on top of that, §4980 imposes a 20% excise tax on the reversion (which can climb to 50% in some circumstances applicable to pension reversions generally).

So an employer who deducted contributions on the way in can end up paying ordinary tax plus a substantial penalty on the way out. The tax benefits that made the 401(h) attractive during the accumulation years can be substantially clawed back if the account is overfunded relative to actual retiree medical claims.

This is why conservative funding matters more with a 401(h) than with almost any other qualified plan feature. With a defined benefit plan, overfunding creates problems, but there are mitigation strategies — benefit increases, plan mergers, qualified replacement plans. With a 401(h) account, the toolbox is smaller.

The practical takeaway for plan sponsors is to fund toward realistic, actuarially supportable medical cost projections rather than the maximum the deduction rules might allow. A 401(h) works best as a benefit that gets spent, not a tax shelter that gets stockpiled.

For a provision that has been in the Code since 1962, §401(h) has generated remarkably little authoritative guidance. The core regulations at Treas. Reg. §1.401-14 date to the early 1970s and have never been meaningfully updated. Beyond that, practitioners are working with a patchwork: the deduction rules in Treas. Reg. §1.404(a)-3(f), a handful of revenue rulings, and a scattered body of private letter rulings that, by law, can't be relied upon by anyone other than the taxpayer who requested them.

That vacuum forces judgment calls on questions that matter. How exactly does the subordination test interact with certain contribution structures? What happens in edge cases involving key employee accounts, plan mergers, or transfers? How do the old rules map onto plan designs and funding environments that didn't exist when the regulations were written? Reasonable practitioners can and do disagree, and the answer a sponsor gets often depends on which advisor they ask. Some firms take aggressive positions in the gray areas; others refuse to touch designs that lack clear support. Neither approach is provably wrong, which is precisely the problem — the sponsor bears the risk of the interpretation, and there's no safe harbor to stand on.

The limited guidance also has a chilling effect on the market itself. Many TPAs, actuaries, and even ERISA attorneys have little or no hands-on experience with 401(h) accounts, in part because the uncertainty makes the feature harder to administer and defend on audit.

That thins the pool of qualified providers, raises the cost of getting competent advice, and means sponsors sometimes get 401(h) accounts bolted onto plans by promoters who don't fully understand the rules — which is exactly the pattern that attracted IRS scrutiny to abusive arrangements in the past. Until the Service issues updated guidance, the 401(h) will remain a powerful but sparsely mapped corner of the qualified plan world, best navigated with advisors who have actually done the work rather than those learning on the sponsor's dime.

None of these disadvantages makes the 401(h) a bad tool — they make it a specialized one. The triple tax advantage is real, and for the right employer it can fund retiree healthcare more efficiently than almost any alternative.

But the account only works when the underlying facts cooperate: a business that genuinely benefits from sponsoring a pension plan, retirement contributions large enough to support meaningful medical funding under the subordination test, and a realistic expectation that retirees will actually spend the money on qualified medical expenses. When those conditions aren't present, the constraints stop being fine print and start being the whole story.

If you're weighing a 401(h), the honest test is simple. Would you have the host pension plan even without the medical account? Are your retiree medical projections built on real actuarial assumptions rather than the maximum deduction the rules might allow? And is the advisor recommending the design someone who has actually administered these accounts, not just read about them? If the answer to all three is yes, the disadvantages become manageable trade-offs rather than deal-breakers.