401(h) vs Section 115 Trust: Public-Sector Retiree Medical Funding

Section 115 of the Internal Revenue Code provides a specific exclusion from gross income for income derived from the exercise of any essential governmental function and accruing to a state or any political subdivision thereof. This unique tax status has made Section 115 trusts a popular and effective vehicle for public employers seeking to pre-fund Other Post-Employment Benefits (OPEB), including critical retiree medical benefits.

These trusts are typically established as irrevocable entities to hold assets earmarked solely for OPEB liabilities. Their primary advantage lies in the tax-exempt status of their investment earnings, which accumulate free from federal income tax. This allows for more rapid growth of assets dedicated to future retiree healthcare costs, a significant concern for many state and local governments facing mounting OPEB obligations. The structure provides a dedicated funding mechanism, separating these assets from general operating funds and offering a level of security for future benefit payments.

The fundamental distinction between a 401(h) account and a Section 115 trust lies in their structural foundation and regulatory environment. A 401(h) account is not a standalone plan; it must be an ancillary account within a qualified pension or annuity plan. This means it is governed by the rules applicable to its host retirement plan, including ERISA (for non-governmental plans, though governmental plans are exempt) and the Internal Revenue Code sections specific to qualified plans.

In contrast, a Section 115 trust operates as a standalone entity in a public-sector context. It is explicitly designed for governmental entities and relies on the governmental-function income exclusion of Section 115. This distinction impacts everything from governance and accounting standards (e.g., GASB for public entities) to the specific legal frameworks and compliance requirements that apply. While both aim to fund retiree medical benefits, their regulatory homes and operational mandates differ significantly.

The choice between a 401(h) account and a Section 115 trust often depends on the employer's nature and existing benefit ecosystem. Private-sector sponsors, not eligible for Section 115 trusts, typically consider other funding vehicles such as 401(h) accounts (if they have a qualified pension plan), Voluntary Employees' Beneficiary Associations (VEBAs) under Section 501(c)(9), or Health Reimbursement Arrangements (HRAs).

Public-sector sponsors, however, often weigh Section 115 trusts as a primary option, alongside potentially using 401(h) if they sponsor a qualifying governmental pension plan. The

While both vehicles serve to fund retiree medical benefits, their funding mechanisms and any associated contribution limits operate under different rules. Contributions to a 401(h) account are tied directly to the contributions made to the underlying pension plan. Specifically, employer contributions for medical benefits cannot exceed 25% of the employer's aggregate contributions made to the pension plan (other than amounts allocated to fund past service credits) after the medical benefits were first included.

Section 115 trusts, on the other hand, do not have explicit IRS-imposed contribution limits in the same way. Contributions are typically determined by actuarial valuations of the OPEB liabilities, aiming to reach a fully funded status over time. The funding strategy for a Section 115 trust is usually driven by accounting standards like those set by the Governmental Accounting Standards Board (GASB) and the entity's overall financial health and funding policy, rather than strict IRS percentages related to another plan.

The investment of assets held within these funding vehicles, along with the associated fiduciary responsibilities, also presents notable differences.

For 401(h) accounts, because they are part of a qualified pension plan, the investment rules generally align with those governing the pension plan assets. Fiduciaries must act prudently and solely in the interest of participants and beneficiaries, adhering to a high standard of care. While governmental plans are often exempt from ERISA's fiduciary provisions, they typically operate under similar state-level prudence standards.

Section 115 trusts are likewise subject to fiduciary duties, often outlined in state statutes or the trust's governing documents. Assets must be invested prudently and for the exclusive benefit of the retirees. While specific investment rules might vary by state and trust agreement, the overarching principle is to ensure the long-term solvency of the fund to meet OPEB obligations. Many Section 115 trusts engage professional asset managers to navigate complex investment landscapes, aiming for optimal growth while managing risk.

Both 401(h) accounts and Section 115 trusts offer significant tax advantages, albeit through different mechanisms unique to their structures and the employers who can utilize them.

For 401(h) accounts, employer contributions are generally tax-deductible when made to the pension plan. The investment earnings within the 401(h) account grow tax-free, similar to the pension assets. When benefits are paid to retirees, they are typically tax-free to the recipient if used for qualified medical expenses, making them highly valuable to beneficiaries.

Section 115 trusts primarily benefit from the exclusion from gross income for income earned on trust assets, as per Section 115 of the Internal Revenue Code. This means investment earnings accumulate tax-free, significantly enhancing the trust's ability to grow funds to meet future liabilities. For governmental employers, while direct

Compliance and oversight frameworks differ substantially, reflecting the distinct legal underpinnings of each funding vehicle. 401(h) accounts, as components of qualified plans, must adhere to the intricate rules of the Internal Revenue Code (e.g., non-discrimination, separate accounting for medical benefits) and, if applicable, ERISA. Regular reporting to the IRS is required, and plan operations are subject to scrutiny during audits.

Section 115 trusts for OPEB are largely governed by state and local laws, as well as the rules established by organizations like the Governmental Accounting Standards Board (GASB). GASB pronouncements, such as GASB Statement 75, mandate rigorous accounting and financial reporting for OPEB liabilities and assets, requiring actuarial valuations and transparent disclosure. While not subject to ERISA or many of the specific IRS rules for qualified plans, these trusts must ensure their operations remain consistent with the governmental function exclusion of Section 115 to maintain their tax-exempt status. Regular audits and adherence to trust agreements are paramount.