401(h) vs 401(k): The Differences Owners Actually Need to Know

While both 401(k) and 401(h) plans share the '401' prefix from the Internal Revenue Code, they serve fundamentally different purposes and operate under distinct regulatory frameworks. A 401(k) is a defined contribution retirement plan governed primarily by Section 401(k) and related deferral rules, designed to help employees save for retirement through salary deferrals and employer contributions. Participants typically direct their own investments within chosen funds.

Conversely, a 401(h) account is a sub-account authorized by Section 401(h) inside a qualified pension or annuity plan. This is typically a defined benefit (DB) plan or a cash balance plan. The 401(h) is explicitly designed to provide medical benefits for retired employees, their spouses, and dependents. It cannot exist as a standalone plan or directly attach to a 401(k).

The way these plans are funded highlights another major distinction. 401(k) contributions come largely from employee elective deferrals, allowing employees to contribute a portion of their pre-tax paycheck. Employers often provide matching contributions or profit-sharing contributions, which can be discretionary or formula-based.

In contrast, 401(h) contributions come exclusively from employer funding. The contribution amount is determined by the plan's actuary, based on the projected medical costs for retirees. These employer contributions are subject to specific IRS requirements, notably the 'incidental benefit limit,' which dictates that the aggregate contributions for medical benefits cannot exceed 25% of the aggregate contributions to the pension plan (excluding contributions for past service). This limit ensures the primary purpose of the main plan remains retirement benefits, with retiree medical being an 'incidental' benefit.

How participants access and are taxed on benefits also differs significantly. A 401(k) plan accumulates retirement savings that the participant draws on in retirement. These distributions are generally taxed as ordinary income, though qualified distributions from a Roth 401(k) are tax-free. Withdrawals before retirement age typically incur penalties unless an exception applies.

401(h) funds, when used for qualified medical expenses for retirees, are generally not taxable to the retiree. This tax-free benefit for medical distributions is a significant advantage. The benefits paid out are determined by the terms of the underlying pension plan and the 401(h) sub-account, often covering premiums for health insurance, out-of-pocket medical costs, or other eligible healthcare expenditures. The goal is to provide a defined medical benefit rather than a lump sum of savings.

Both 401(k) and 401(h) plans offer significant tax advantages, though they benefit different aspects of an owner's financial strategy. Contributions to a 401(k), whether employee deferrals or employer contributions, grow tax-deferred until withdrawal. Employer contributions are typically tax-deductible for the business.

For a 401(h), employer contributions are also tax-deductible for the business. Critically, these funds grow tax-free within the trust, and as noted, distributions for qualified medical expenses are tax-free to the recipients. This dual tax benefit – deductibility for the business and tax-free distributions for medical expenses – makes the 401(h) a powerful tool for funding retiree healthcare in a highly tax-efficient manner that is unavailable through other post-retirement health savings vehicles like HSAs once an individual is enrolled in Medicare.

While 401(h) plans are less common than 401(k)s, they offer unique benefits, especially for profitable small businesses, professional practices (like doctors' offices), and high-income owners. The primary draw is the ability to pre-fund future retiree medical expenses with tax-deductible contributions, which can be substantial. For owners looking to accelerate business deductions and build significant wealth outside of traditional retirement accounts, a 401(h) paired with a defined benefit plan is particularly attractive.

It allows owners to capture large tax deductions for contributions that ultimately benefit themselves and their employees for essential healthcare costs in retirement. This can be a compelling strategy for mitigating future healthcare cost burdens, which are a major financial concern for many retirees.

Yes — and frequently do. In fact, for many small business owners and high-income earners looking to maximize their tax-advantaged savings and benefits, combining these plans is a strategic move. The structure often involves using different plans to address different financial goals:

For business owners, understanding how 401(k) and 401(h) plans can work together is key to building a robust benefits package. This integrated approach not only provides traditional retirement savings through the 401(k) but also addresses the often-overlooked challenge of funding retiree healthcare costs via the 401(h). This comprehensive strategy can be a powerful tool for attracting and retaining talent, while also offering substantial personal tax benefits to the business owner.

By layering these plans, owners can optimize their business deductions, potentially reduce their taxable income, and secure significant funds for their own and their employees' future medical needs. It's a sophisticated strategy that requires careful planning and actuarial expertise but can yield considerable advantages for those who qualify.