401(h) Plan: Rules for Funding Retiree Medical Benefits

A 401(h) account is a specialized savings vehicle established within a pension or annuity plan, designed exclusively for funding the future medical expenses of retired employees. It permits employers to systematically set aside funds for retiree healthcare obligations in a tax-advantaged manner. This structure allows contributions to grow tax-free, and when used for their intended purpose, distributions are also tax-free to the retiree. This financial tool is not a standalone health savings plan but an ancillary feature of a primary retirement plan, governed by specific regulations that dictate how it must be created, funded, and administered.

Establishing a 401(h) Account

A 401(h) account cannot exist independently; it must be formally attached to a qualified pension or annuity plan. This means it is part of a defined benefit pension plan or a money purchase pension plan. The legal framework for the medical benefits must be explicitly detailed within the official written document of the main retirement plan.

A requirement under Internal Revenue Code Section 401(h) is the maintenance of separate accounting. All funds contributed to the 401(h) account must be held distinctly from the assets intended for retirement income benefits. This segregation applies to all financial activities, though the plan can invest the 401(h) assets with the retirement assets.

The main regulation is the subordination requirement, which mandates that medical benefits must be secondary to the plan’s purpose of providing retirement benefits. To enforce this, aggregate contributions to the 401(h) account cannot exceed 25% of the total aggregate contributions made to the entire plan since the account’s inception, excluding contributions for past service credits. For example, if total contributions to the pension portion equal $750,000, contributions to the 401(h) account cannot exceed $250,000, keeping the medical portion at 25% of the $1,000,000 grand total.

Funding the 401(h) Account

A 401(h) account may be funded by employer contributions, and depending on the plan’s specific rules, employees may also be permitted to contribute. Employer contributions are tax-deductible in the year they are made, providing an immediate tax benefit for pre-funding future retiree health obligations.

Contributions must be “reasonable and ascertainable.” This means the employer cannot simply contribute arbitrary amounts. The funding level must be based on a logical calculation tied to the projected costs of providing the promised medical benefits, which often involves actuarial calculations. Employers must carefully track contributions to both portions of the plan to maintain compliance with the subordination rule.

Using 401(h) Account Funds

Funds held within a 401(h) account are strictly designated for specific beneficiaries and purposes. The eligible recipients of these benefits are retired employees, their spouses, and their dependents. An individual is considered “retired” for this purpose when they have met the age and service requirements to begin receiving retirement benefits under the pension plan. In some cases, an active employee who has met these requirements may be eligible for distributions.

Distributions from the account must be used exclusively to pay for or reimburse qualified medical expenses. The definition of a qualified medical expense is determined by the same standard used for the medical expense deduction on individual income tax returns. Common examples include payments for health insurance premiums, prescription medications, and dental care.

An advantage of the 401(h) structure is the tax treatment of these distributions. When funds are paid for qualified medical expenses, the distribution is entirely tax-free to the recipient. The plan document must specify that payments are for sickness, accident, hospitalization, and medical care. The money cannot be distributed to retirees as a cash payment for non-medical purposes or rolled over into another type of account.

Forfeiture and Reversion of Assets

The rules for handling surplus 401(h) assets prioritize fulfilling promised benefits. Before any other action can be taken, all funds in the account must be used to satisfy all outstanding liabilities for medical benefits owed to eligible retired employees, their spouses, and dependents. This obligation takes precedence over any other potential use of the funds.

Once all medical benefit liabilities have been fully satisfied, any remaining assets in the account must revert to the employer. This reversion is a mandatory step dictated by Treasury Regulations, and the employer is then responsible for paying income tax on the reverted amount.

A rule is that any excess funds within the 401(h) account cannot be transferred to the retirement portion of the plan to fund pension benefits. This prevents employers from overfunding the medical account as an indirect way to fund the pension. If an individual employee’s interest in the medical benefits account is forfeited before the plan’s termination, those forfeited amounts must be used to reduce future employer contributions.