The #1 Strategy to Max Your 401(h) While Minimizing Payroll Tax

Every S corporation owner knows the tension. Take a bigger salary and you hand more money to payroll taxes. Take a smaller salary and you may limit what you can put into your retirement plan — because most retirement contributions are tied directly to your W-2.

But there's one account that plays by different rules: the 401(h). Understanding how it interacts with your W-2 opens the door to a strategy that lets you keep your salary modest, minimize payroll taxes, and still build a substantial stack of tax-favored contributions every year.

Here's how it works.

A 401(k) is the workhorse of retirement savings. As an employee — including an employee of your own S corporation — you can defer a portion of your W-2 wages into the plan before income tax. For 2026, the employee deferral limit is $24,500, plus an $8,000 catch-up if you're 50 or older. Your business can also make employer contributions on top of that, such as profit sharing.

But here's the constraint that matters for this discussion: 401(k) contributions are tethered to your compensation. You cannot defer more than you earn, and the total annual additions to your account (your deferrals plus employer contributions) can never exceed 100% of your W-2 wages. Earn a $30,000 salary, and $30,000 is your absolute ceiling — no matter what the dollar limits say.

This is true of defined contribution plans generally. The 100%-of-compensation limit is a hard wall. And it's exactly why the 401(h) is so interesting.

A 401(h) is a medical expense account that attaches to a defined benefit plan (such as a cash balance plan) or a money purchase plan. Contributions are tax-deductible to the business, grow tax-free, and come out tax-free when used for qualified medical expenses in retirement.

Here's the part most people miss: 401(h) contributions are not subject to the 100%-of-compensation limit that governs defined contribution plans.

For a business owner, 401(h) contributions do count toward the overall dollar limit on annual additions ($72,000 for 2026) — but the compensation-based percentage limit simply does not apply to them. That's not an aggressive interpretation; it's an explicit carve-out in the rules.

Think about what that means. A defined contribution plan looks at your $30,000 W-2 and says, "You may receive $30,000, and not a penny more." The 401(h) doesn't ask that question. Its limits are driven by the contributions flowing into the host retirement plan (more on that below) and the overall dollar ceiling — not by the size of your paycheck.

The result: you can make meaningful 401(h) contributions on a very low W-2. And a low W-2 means low payroll taxes. On an S corporation salary, you and your business split 15.3% in Social Security and Medicare taxes on every dollar of wages. Drop the salary from $150,000 to $30,000 and you're saving roughly $18,000 per year in payroll taxes alone — while the 401(h) keeps working at full strength.

Any S corporation owner reading this should immediately ask the right question: doesn't the IRS require me to pay myself a reasonable salary?

Yes. S corporation owners who perform services for their business must take reasonable compensation before taking distributions. The IRS actively looks for owners who zero out or minimize their W-2 purely to dodge payroll taxes, and courts have recharacterized distributions as wages when the salary was indefensibly low.

But here's the nuance that gets lost: reasonable compensation is measured by the total package, not the paycheck alone. When examiners and courts evaluate whether an owner's compensation is reasonable, the analysis includes fringe benefits and retirement contributions — not just the W-2 box.

This is where the strategy becomes defensible rather than aggressive. Consider two owners:

• Owner A takes a $30,000 salary and nothing else. Distributions of $120,000 flow out the side door. This looks exactly like what the IRS targets.
• Owner B takes a $30,000 salary — but the business also funds a cash balance plan contribution, a 401(k), and a 401(h) medical account on her behalf, worth tens of thousands of dollars per year. Her total compensation package may exceed $90,000.

Owner B isn't underpaying herself. She's simply taking a large share of her compensation in the form of extraordinarily valuable benefits instead of taxable wages. A rich benefits package — particularly a defined benefit pension and a retiree medical account, benefits most employees could only dream of — substantially strengthens the argument that the overall compensation arrangement is reasonable.

To be clear: reasonable compensation is always a facts-and-circumstances question. Your industry, your role, your hours, and comparable salaries all matter, and you should document the analysis with your CPA. But a low salary paired with generous, formally established benefits is a very different posture than a low salary standing alone.

Let's put numbers on it. Meet a 50-year-old S corporation owner — say, a consultant — whose business generates $150,000 of net income. Instead of running most of it through payroll, she sets her W-2 at $30,000 and adopts a cash balance plan with an attached 401(h) account, alongside a 401(k).

Is $30,000 low? On its face, maybe. But layer in the benefits her corporation provides — a defined benefit pension accrual, retirement plan contributions, and a funded retiree medical account — and the total value of her compensation package tells a very different story. That's the package a reasonable compensation analysis should evaluate.

Here's what her annual contribution stack could look like for 2026:

Look at that bottom line. She's directing roughly $64,500 into tax-advantaged accounts — more than double her W-2 — while paying Social Security and Medicare tax on only $30,000 of wages. Had she taken the full $150,000 as salary, the combined payroll tax bill (employee and employer shares) would run close to $23,000. At a $30,000 salary, it's about $4,600. That's roughly $18,000 per year staying in her pocket, year after year.

A few honest caveats about the table:

• The cash balance figure is illustrative. Defined benefit contributions are calculated by an actuary based on age, compensation history, and plan design. A low W-2 does constrain the maximum pension benefit over time, so the cash balance number here is deliberately conservative. Owners who run a higher salary for a few years can support substantially larger cash balance contributions.
• The 401(h) figure is governed by the subordination requirement. Medical account contributions must stay subordinate to the retirement contributions in the host plan — as a rule of thumb, roughly one-third of the retirement funding. A bigger cash balance contribution supports a bigger 401(h) contribution.
• The catch-up contribution can push the 401(k) number higher, though total deferrals can never exceed actual wages after payroll taxes.

Even with conservative assumptions, the structure is remarkable: the 401(h) and cash balance plan do heavy lifting that a standalone 401(k) simply cannot do on a $30,000 W-2.

The 401(h) occupies a rare position in the planning landscape. It's the only account that combines a business deduction going in, tax-free growth, and tax-free distributions for retirement medical expenses — and unlike defined contribution plans, its funding capacity isn't chained to the size of your paycheck.

For S corporation owners, that combination unlocks a genuinely powerful strategy: keep the W-2 modest, minimize payroll taxes, and let a cash balance plan and 401(h) account deliver the bulk of your compensation in tax-favored form. The generous benefits package doesn't just build wealth — it's also a central part of what makes the lower salary defensible in the first place.

But make no mistake: this is sophisticated planning. It requires a properly designed defined benefit plan, an actuary certifying the contributions, a documented reasonable compensation analysis, and ongoing administration to keep the 401(h) subordination math in line. Done casually, a low-salary strategy invites scrutiny. Done correctly — with the plan documents, actuarial work, and compensation study to back it up — it's one of the most efficient structures available to a profitable business owner.

If you're taking a large salary today primarily to feed your retirement plan, it's worth asking whether you're solving the right problem. The right plan design may let you contribute more while paying yourself — and the payroll tax system — considerably less.