Why 401(h) Contributions Can Exceed Your Compensation

Most practitioner writing on 401(h) accounts gets one sentence into §415(l)(1) and stops. The first sentence is the famous one: contributions to an individual medical benefit account are treated as annual additions to a defined contribution plan, which is how a medical account riding on a defined benefit plan ends up capped by the defined contribution dollar limit ($72,000 for 2026). That rule is widely known, widely cited, and — for the low-salary business owner — only half the story.

The second sentence is the one almost nobody writes about, and it's the one that matters most for the S-corp owner running modest W-2 wages: the 100%-of-compensation limit does not apply to the 401(h) contribution. Only the dollar limit does. That makes the 401(h) contribution unique among qualified-plan allocations — it is the one annual addition that can lawfully exceed the participant's compensation.

This article walks through the statutory language, why the carve-out exists structurally, what it means in dollars for a low-W-2 owner, and the limits it does not override.

§415(c)(1) caps a participant's annual additions at the lesser of two prongs:

• (A) the dollar limit — $72,000 for 2026, indexed annually; or
• (B) 100% of the participant's compensation.

For ordinary defined contribution money — deferrals, profit sharing, money purchase contributions — both prongs apply, and whichever is lower wins. A participant with $50,000 of compensation cannot receive more than $50,000 of regular annual additions no matter how large the dollar limit is.

§415(l)(1) then does two things in two sentences. The first sentence sweeps 401(h) money into this regime: contributions allocated to any individual medical benefit account that is part of a pension or annuity plan are treated as an annual addition to a defined contribution plan for purposes of subsection (c). The second sentence turns one prong back off: subparagraph (B) of subsection (c)(1) — the compensation prong — does not apply to any amount treated as an annual addition under the first sentence.

The net effect: the 401(h) contribution is tested against the dollar limit only. The IRS's own examiner training manual on §401(h) retiree medical benefits quotes this language in full in its Section 415 discussion, and the regulations at Treas. Reg. §1.415(c)-1 confirm that individual medical benefit account contributions under §401(h) are treated as defined contribution plan contributions pursuant to §415(l)(1).

Congress used the same pattern elsewhere, incidentally: §415(c)(2) contains a parallel rule providing that the compensation prong does not apply to certain post-separation medical benefit contributions under §419A(f)(2). Switching off prong (B) for medical money is a deliberate structural choice, not a drafting accident.

The compensation prong exists to tie retirement savings to earnings — the intuition being that you shouldn't be able to shelter more than you made. Medical benefits break that logic. The cost of funding retiree healthcare has nothing to do with what the participant earns in a given year; a $50,000-salary owner and a $500,000-salary owner face roughly the same actuarial cost for the same medical benefit.

Capping the medical funding at compensation would make the benefit arbitrarily unfundable for anyone with modest wages, which is precisely the population — retirees-to-be with real future medical costs — the provision was meant to serve. So Congress kept the dollar ceiling as an anti-abuse backstop and dropped the compensation tether.

Consider a solo S-corp owner, age 55, taking $50,000 in W-2 wages, sponsoring a defined benefit plan with a 401(h) account. (As a sole owner she is a key employee, so her 401(h) money sits in an individual medical benefit account and §415(l) applies — there's no pooled-account alternative in an owner-only plan.)

Regular DC contributions: capped at the lesser of $72,000 or 100% × $50,000 = $50,000. The compensation prong binds.

The 401(h) contribution: tested against the dollar limit only. The compensation prong is off. Subject to the other constraints discussed below, the medical account can be funded up to the full $72,000 of annual-addition room — an amount that exceeds her entire W-2 compensation for the year.

Two features of this table are worth pausing on. First, the components share one dollar bucket — the 401(h) doesn't get its own separate $72,000. Second, the combined total ($72,000) exceeds her compensation ($50,000), and that's lawful, because the excess over compensation is entirely medical-account money to which prong (B) doesn't apply. No other qualified-plan structure produces that result.

Now stack them. Suppose she also puts $30,000 into a profit-sharing plan:

Dropping the compensation prong clears exactly one obstacle. Three others remain fully intact, and any of them can be the number that actually binds:

The dollar limit still applies — and it's shared. Every regular DC annual addition for the same owner draws from the same $72,000 pot as the 401(h) contribution. An owner maxing a 401(k)/profit-sharing combination can crowd out most of the medical account's room.

The 25% subordination test still applies. Aggregate contributions to the medical account (plus any life insurance protection) cannot exceed 25% of aggregate plan contributions under Treas. Reg. §1.401-14 — roughly one-third of the pension contribution under the common combined-base reading. A low-W-2 owner whose defined benefit contribution is itself modest will often find this test, not §415, sets the ceiling.

The §404 deduction limit still applies. The contribution is deductible only up to the actuarially reasonable cost of funding the medical benefit actually defined in the plan. The carve-out lets the contribution exceed compensation; it does not let it exceed what the benefit costs to fund.

In other words: §415(l)(1)'s second sentence removes the constraint that would have made the 401(h) nearly useless for low-wage owners, but it doesn't hand out free capacity. The binding limit in any given year is still the lowest of the dollar limit, the subordination ceiling, and the deduction ceiling.

For the right fact pattern — an incorporated owner deliberately running lean W-2 wages, a well-funded defined benefit plan, and real anticipated retiree medical costs — the carve-out changes the design conversation:

• The 401(h) is the one place qualified-plan dollars can exceed compensation. For an owner whose wage strategy caps every other contribution type, the medical account is incremental capacity that no salary increase is needed to unlock.
• Wage-setting and 401(h) funding should be coordinated, not sequenced. Because the medical account ignores compensation, the usual "raise W-2 to raise contribution room" logic applies only to the retirement side. The medical side keys off the pension contribution (via subordination) and the benefit design (via §404).
• Watch the stacking order. If both regular DC contributions and a 401(h) are in play, the regular contributions consume dollar-limit room that the medical account cannot get back. Deciding how much of the $72,000 bucket to allocate to each is a genuine design decision, not an afterthought.

The well-known rule — 401(h) contributions count against the defined contribution dollar limit — is true but incomplete. The second sentence of §415(l)(1) is where the planning value lives: the compensation prong is switched off, making the 401(h) contribution the only annual addition that can exceed what the participant earns.

For the low-W-2 business owner, that transforms the medical account from a rounding error into meaningful, deductible, tax-free-at-distribution funding capacity — provided the subordination test and the §404 deduction ceiling cooperate.