The 401(h) Loophole That Allows Contributions to Exceed Compensation

A 401(h) account is a specialized, separate sub-account established within a qualified "pension" plan. Its exclusive purpose is to pre-fund retiree medical, and dental for eligible employees, their spouses, and dependents.

Unlike standard retirement vehicles, a 401(h) account functions as a structural carve-out within the broader pension architecture, allowing employers to make tax-deductible contributions that accumulate tax-free. Upon retirement, the funds can be distributed completely tax-free to reimburse qualified healthcare premiums and out-of-pocket medical expenses, granting these accounts a rare "triple-tax-free" status under the Internal Revenue Code.

But are 401(h) contributions limited by compensation?

To understand the mechanics, we have to look directly at the Internal Revenue Code. Section 415(c)(1) states that annual additions to a defined contribution plan cannot exceed the lesser of two numbers:

• The Dollar Limit: A fixed statutory amount (e.g., $72,000 for 2026).
• The Compensation Limit: 100% of the participant's compensation.

For traditional defined contribution plans like 401(k)s and profit-sharing plans, both limits apply rigidly. However, when you introduce an individual medical benefit account under Section 401(h), Section 415(l)(1) throws a curveball. The IRS manual explicitly clarifies that amounts allocated to a 401(h) individual medical account are treated as annual additions for testing the dollar limitation, but not for the percentage of compensation limitation.

The statute essentially dictates: Treat the 401(h) medical account funding as an annual addition for the dollar limit, but completely disregard the 100% of compensation limit.

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.

Let's look at what this means for a closely held business owner operating as an S-corporation. Often, these owners take a modest, reasonable W-2 salary. Let's assume $50,000. This allows the rest of their income to be distributions in order to limit payroll taxes.

The Problem: With a $50,000 salary, their maximum standard defined contribution allocation (e.g., a 401(k) and profit-sharing plan) is capped at $50,000 by the 100% limit, leaving $22,000 of the 2026 $72,000 Section 415(c) dollar limit entirely unused.

The 401(h) Solution: The business sets up a defined benefit or cash balance plan with a subordinate 401(h) account.

The Math: The owner maxes out their 401(k) at $50,000 (hitting the 100% compensation limit for that specific plan). The remaining $32,000 in dollar-limit space can now be legally allocated to the 401(h) account.

Because the 401(h) allocation is legally exempt from the 100% compensation rule, the participant successfully receives a total of $72,000 in tax-advantaged annual additions on just $50,000 of W-2 compensation.

While the 100% compensation exemption is powerful, it is not a blank check. Practitioner enthusiasm must be tempered by the other statutory guardrails that remain fully in effect:

• The 415(c) Dollar Limit: The 401(h) allocation is still an annual addition. When aggregated with other defined contribution plan additions, the combined total cannot exceed the hard dollar limit.

• The Subordination Requirement: Under Section 401(h), the medical benefits must be subordinate to the retirement benefits. The cumulative contributions to the medical account cannot exceed 25% of the total actual contributions to the pension plan (other than past service credits) since the medical account was established.

• Actuarial Justification: You cannot just arbitrarily deposit cash into a 401(h) to max out the dollar limit. The contribution must be based on reasonable, actuarially determined estimates of post-retirement medical expenses.

• Deduction Limits: The employer must still navigate the Section 404 rules regarding the deductibility of contributions to the pension plan and the medical account.

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, this loophole 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.

Why did Congress write this specific carve-out? It comes down to the fundamental difference between retirement income and medical expenses.

Retirement pensions are designed to replace a portion of working income, so tying contribution limits to a percentage of compensation makes structural sense. Healthcare costs, however, are an absolute dollar expense. A knee replacement costs the same whether the patient earned $40,000 or $400,000 before retiring.

If Section 415 restricted 401(h) medical account funding to 100% of compensation, it would actively prevent the funding of retiree medical benefits for lower-paid employees, defeating the account's intended purpose. The carve-out acknowledges that medical funding needs to be driven by actuarial costs, not capped by an arbitrary W-2 constraint.

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.