The 25% Rule, the Dollar Cap, and the 10% Secret: The 3 Limits That Control Your 401(h)

The 401(h) account might be the best-kept secret in retirement planning. It lets a business make tax-deductible contributions to a medical expense fund, lets that money grow without being taxed, and then lets it come out completely tax-free when used for healthcare costs in retirement. No other account delivers that combination at meaningful contribution levels.

But "meaningful" is not "unlimited." The IRS places real guardrails around how much can go into a 401(h) account, and those guardrails come from three separate directions at once. Understanding all three — and how they work together — is the key to funding the account properly, because your actual contribution limit in any given year is whichever of the three rules bites first.

Let's walk through each one in plain English.

A 401(h) is a medical benefit account that lives inside a qualified retirement plan. It cannot exist on its own — it must be attached to a "host" plan, which is either a defined benefit plan (including the popular cash balance plan) or a money purchase plan.

The account exists for one purpose: paying qualified medical expenses in retirement. That includes health insurance and Medicare premiums, prescriptions, dental and vision care, and long-term care costs. Because healthcare is often the single largest expense retirees face, having a dedicated, tax-free pool of money for it is enormously valuable.

The tax treatment is what makes the 401(h) special:

• Contributions are deductible to the business,
• Growth is tax-free inside the account, and
• Withdrawals are tax-free when used for qualified medical expenses.

That's the same triple tax benefit as a health savings account — but with far greater funding capacity. Which brings us to the natural question: exactly how much can you contribute?

Unlike a 401(k), where one headline number tells you the annual limit, the 401(h) doesn't have a single fixed dollar cap printed in an IRS table. Instead, your maximum contribution is shaped by three overlapping rules:

• The 25% rule — the medical account must stay subordinate to the retirement plan it's attached to.
• The overall annual additions cap — for business owners, 401(h) contributions count against the yearly dollar ceiling that applies to defined contribution accounts.
• The deduction limit — contributions must be tied to the actual projected cost of the medical benefits and funded on a permitted schedule.

Each rule measures something different. One looks at the relationship between the medical account and the retirement plan. One looks at a fixed annual dollar cap. And one looks at whether the funding is justified by real, actuarially estimated medical costs. A contribution has to clear all three to be fully allowed and fully deductible.

Here's each rule in detail.

The first and most famous limit reflects the 401(h)'s fundamental design principle: the medical benefit must always be the sidecar, never the motorcycle. The retirement plan is the main event; the medical account rides along.

The rule works like this: the total contributions made to fund the medical benefits (plus any life insurance protection in the plan) cannot exceed 25% of the total contributions made to the plan — measured on a cumulative basis from the time the medical benefits were added, and excluding contributions that fund past service credits.

A quick way to think about it: for every $3 of retirement funding, roughly $1 of medical funding can ride along. If your cash balance plan receives $90,000 of retirement contributions, that supports up to about $30,000 of 401(h) contributions — because $30,000 is 25% of the $120,000 combined total.

Two practical takeaways:

The test is cumulative, not year-by-year. It looks at aggregate contributions since the medical benefits were added to the plan. That gives some flexibility — a year of heavier medical funding can be balanced against years of heavier retirement funding — but the running total must always stay in line. Bigger retirement contributions unlock bigger medical contributions. This is why a defined benefit or cash balance host plan is so much more powerful than a money purchase plan: the larger the retirement funding, the larger the 401(h) capacity that comes with it.

The second limit is a dollar ceiling. Each year, the IRS sets a maximum on the total "annual additions" that can go into a person's defined contribution accounts — the combined total of employee deferrals and employer contributions. For 2026, that ceiling is $72,000.

Here's where the 401(h) comes in: for business owners and other key people in the company, contributions to their 401(h) account are counted toward that same annual dollar ceiling. The medical account contributions get stacked on top of the owner's 401(k) deferrals and other defined contribution amounts, and the combined total cannot exceed the cap.

An example makes it concrete. Suppose a business owner defers $24,500 into her 401(k) for 2026. That leaves $47,500 of room under the $72,000 ceiling. Her 401(h) contributions for the year would need to fit within that remaining space — along with any employer profit sharing or other defined contribution amounts.

One helpful nuance: while the 401(h) contribution counts toward the dollar ceiling, it is not held back by the separate rule that limits defined contribution amounts to 100% of your salary. That distinction matters enormously for owners who take modest W-2 wages — the medical account can be funded well beyond what a percentage-of-pay test would allow. But the fixed dollar cap still stands, and in practice it's often the binding constraint for owners who are already maximizing their 401(k).

Note that this cap is aimed at owners and key personnel, whose medical benefits must be tracked in individual accounts. Rank-and-file medical benefits are handled differently and don't consume the employees' individual annual additions room in the same way.

The third limit answers a different question entirely. The first two rules ask "how much can go in?" This one asks "how much can the business deduct?" — and it forces the funding to be grounded in reality.

The rule has two parts:

Part one: the total cost ceiling. Cumulative contributions to the 401(h) cannot exceed the total cost of actually providing the promised medical benefits. That cost isn't a guess or a wish — it must be determined using a generally accepted actuarial method that is reasonable given the plan's provisions, who is covered, and how the benefits are funded. In other words, an actuary projects what your retirement medical benefits will genuinely cost, and that projection becomes the lifetime funding target. You cannot simply stuff the account because the tax benefits are attractive.

Part two: the annual pacing rule. Even within that lifetime target, the deduction in any single year is limited to the greater of two amounts:

An amount determined by spreading the remaining unfunded cost evenly over the remaining working years of the covered employees, or 10% of the total cost needed to completely fund the medical benefits.

That second option — the 10% alternative — is quietly one of the most useful features of the whole regime. It means that no matter how the level-funding math works out, the business can always deduct up to one-tenth of the full benefit cost each year. Put differently, a 401(h) can generally be fully funded in as little as ten years. For a 50-year-old owner planning to retire at 60 or later, that timeline fits beautifully.

Two housekeeping points: the employer must pick one method (level funding or the 10% approach) and apply it consistently for all employees — no mixing and matching. And if contributions in a given year exceed the annual limit, the excess isn't lost; it carries forward and becomes deductible in later years as room opens up.

Think of the three rules as three fences around the same field, each running in a different direction:

The 401(h) rewards owners who plan deliberately. The three contribution limits aren't arbitrary hurdles — each one exists to keep the account true to its purpose: a genuinely subordinate, genuinely medical, genuinely cost-justified benefit riding alongside a real retirement plan. Respect the structure, and the IRS gives you something extraordinary in return: deductible contributions, tax-free growth, and tax-free money for what will likely be one of your largest retirement expenses.

Getting the most out of the account means engineering all three limits in concert. The host plan needs to be generous enough to support the medical funding you want under the 25% rule. The owner's other retirement contributions need to be coordinated so the annual dollar cap isn't accidentally exhausted. And the actuarial cost projection needs to be built thoughtfully, because it defines both your lifetime funding target and — through the 10% pacing option — how fast you can get there.