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, 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 three real guardrails around how much can go into a 401(h) account. Understanding all three is the key to funding the account properly.

In this article, we will discuss these three rules in plain English and offer some tips along the way. Let's jump in!

A 401(h) is a medical benefit account that is attached to a qualified pension 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, along with dental and vision care. 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 by 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 (HSA), but with far greater funding capacity. This brings us to the natural question: exactly how much can you contribute?

Unlike a 401(k), where contribution caps are easy to calculate, the 401(h) doesn't have a single fixed dollar cap printed in an IRS table. Instead, your maximum contribution is capped by all three of the following rules:

• The 25% rule — the medical account must stay subordinate to the retirement plan it's attached to. Contributions to the 401(h) can't exceed 25% of the total contributions to the pension plan and 401(h).
• The overall annual additions cap for defined contribution plans. That's right. Even though the account may be tied to a defined benefit plan, 401(h) contributions count against the annual dollar ceiling for defined contribution plans.
• 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 funding relationship between the medical account and the retirement plan. One looks at a fixed annual dollar cap. The final one looks at whether the funding is justified by real, actuarially estimated medical costs. A contribution has to clear all three to be fully tax-deductible.

Here's each rule in detail...

The first and most publicized limit reflects the 401(h)'s fundamental design principle: the medical benefit must always be "incidental" to the pension plan. The retirement plan is the main event and the medical account is the side kick.

The rule works like this: the total contributions made to fund the medical benefits cannot exceed 25% of the total contributions made to the plan. This is measured on a cumulative basis. It excludes contributions made to the pension before the 401(h) account was added.

A quick way to think about it: for every $3 of retirement funding, there is $1 of allowable medical funding. If your cash balance plan receives $90,000 of retirement contributions, that supports a maximum of $30,000 of 401(h) contributions. Because $30,000 is 25% of the $120,000 combined total.

Two practical takeaways:

• Remember 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 a running total is still maintained.
• Bigger retirement contributions unlock bigger medical contributions. This is why a defined benefit or cash balance 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. This is the combined total of employee deferrals and employer contributions. For 2026, that ceiling is $72,000 for someone younger than 50.

Here's where the 401(h) comes in: for business owners, 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 profit-sharing contributions, and the combined total cannot exceed the cap.

An example makes it concrete. Suppose a 40 year old business owner contributes $24,500 into a 401(k) deferral and $10,000 into the 401(k) profit-sharing for 2026. That leaves $37,500 of room under the $72,000 ceiling. The 401(h) contributions for the year would need to fit within that remaining space.

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?"

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 future medical benefits. That cost must be determined using a generally accepted actuarial method that is reasonable given the plan's provisions. In other words, an actuary projects what your retirement medical benefits will genuinely cost, and that projection becomes the lifetime funding target.

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 may 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 52-year-old owner planning to retire at age 62, 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. 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.

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 exceeded. Lastly, 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.