401(h) Account: Funding, Eligible Benefits, and Key Limits

A 401(h) account is a tax-advantaged medical benefit account that an employer attaches to an existing qualified pension or annuity plan under Section 401(h) of the Internal Revenue Code, and its only purpose is paying healthcare costs for retired employees, their spouses, and their dependents. Employer contributions are deductible going in, investment earnings grow tax-free inside the account, and benefit payments come out tax-free to the retiree. In exchange for that triple tax advantage, the account has to follow a rigid set of rules about where it can sit, how it can be funded, and what happens to any money left over.

Where a 401(h) Account Can Live

A 401(h) is never a stand-alone account. It has to be a subordinate part of an employer’s existing qualified pension or annuity plan, and the medical benefits it provides must always stay secondary to the retirement benefits under that plan.¹ In practice that means the host plan is almost always a traditional defined benefit pension or a money purchase pension.

A common assumption is that a 401(h) can be bolted onto a 401(k) or a profit-sharing plan. It cannot. The IRS has been explicit that a 401(h) account is permitted only inside a pension or annuity plan, not inside a profit-sharing plan.² If your retirement program is a 401(k), a 401(h) is not available to you.

The plan document also has to describe the 401(h) account specifically, list the health benefits it will provide, and explain how benefit amounts are calculated. This “reasonable and ascertainable” requirement means a retiree has to be able to look at the plan and figure out what coverage they will actually get.³

Who Puts Money In

Only the employer contributes to a 401(h). Employee contributions of any kind, salary deferrals or after-tax dollars, are prohibited.¹ The account is purely an employer-funded vehicle.

Contributions are tax-deductible in the year made, subject to the overall qualified-plan deduction limits under IRC Section 404. The 401(h) assets have to be held in a trust separate from the pension’s retirement assets, and earnings inside that trust accumulate tax-free. The separate accounting is not a bookkeeping nicety. It is what allows the IRS to verify that funding limits are being respected and that medical money is not being commingled with retirement money.²

Who Can Receive Benefits, and for What

Funds in a 401(h) account can only pay medical costs for retired employees, their spouses, and their dependents. The statute covers expenses for sickness, accident, hospitalization, and medical care, which reaches a broad range of healthcare costs, including post-retirement insurance premiums.³ “Dependent” includes children who have not turned 27 by the end of the calendar year.¹

To count as “retired” for 401(h) purposes, an employee must either be eligible to receive retirement benefits under the pension plan or have been retired by the employer because of permanent disability. Someone still working for the employer does not qualify, even at normal retirement age, if separation from employment is a condition of receiving retirement benefits under the plan.³ Active employees are outside the account entirely.

Payments to eligible retirees are generally tax-free. That treatment flows from IRC Section 105(b), which excludes from gross income amounts paid to reimburse medical expenses under an employer-provided accident or health plan.⁴ The retiree does not report the reimbursement as taxable income.

The 25% Subordination Limit

The single most important funding rule is the subordination test. Total employer contributions for medical benefits, combined with any contributions for life insurance protection under the plan, can never exceed 25% of the total contributions made to the entire plan since the 401(h) account was established, excluding contributions that fund past service credits.¹

Two details about this test regularly trip sponsors up. First, it is cumulative, not annual. Every dollar of pension contributions and every dollar of 401(h) contributions since inception gets added to the running totals, and compliance is measured against those totals. Second, the “date of establishment” is the later of the date the plan amendment creating the 401(h) was adopted or the date it became effective. Sponsors sometimes try a retroactive effective date to enlarge the pension contribution base and squeeze in bigger medical contributions, and the IRS has flagged that as a recurring audit issue.²

Because the calculation runs from the account’s creation forward, meticulous historical records matter. Losing a few years of contribution data can make it impossible to prove the account is inside the 25% line.

The Non-Diversion Rule and What Happens to Surplus

The non-diversion requirement is absolute. Before all medical benefit liabilities have been satisfied, it must be impossible under the plan terms for any part of the account’s assets or earnings to be used for anything other than providing the specified health benefits.¹ The employer cannot tap 401(h) funds to reduce general corporate costs, subsidize other employee benefits, or shore up the pension side of the plan.

If a participant’s interest in the medical account is forfeited before the plan terminates, say, because they leave before becoming eligible, the forfeited amount must be applied to reduce future employer contributions to the 401(h) account.³ The employer cannot absorb it.

When the arrangement terminates and all medical obligations have been met, any surplus reverts to the employer, and that reversion is expensive. The employer owes an excise tax of at least 20% of the reverted amount.⁵ The rate rises to 50% unless the employer establishes a qualified replacement plan or provides pro-rata benefit increases to participants under the terminating plan.⁶ Stacked on top of regular corporate income tax on the reversion, the 50% rate can consume nearly all of a surplus, which is why most sponsors calibrate contributions to avoid building one in the first place.

Moving Excess Pension Assets In: Section 420 Transfers

IRC Section 420 lets an employer move surplus assets from an overfunded defined benefit pension into the 401(h) account without triggering the reversion excise tax or disqualifying the plan.⁷ Without Section 420, that kind of transfer would be a prohibited reversion.

A qualified transfer has to meet several conditions:

One qualified transfer per plan per tax year. A transfer to a health benefits account and a transfer to an applicable life insurance account in the same year count together as one.
The transferred amount cannot exceed what the employer reasonably estimates it will pay from the account during the transfer year for current retiree health liabilities.
Transferred assets, and any income on them, can be used only to pay current retiree health liabilities for the year of the transfer. Benefits for key employees are excluded from this pool.
The transfer has to satisfy the separate vesting and minimum cost requirements laid out in the statute.

The authority to make qualified transfers currently sunsets on December 31, 2032. Transfers made after that date will not get favorable tax treatment unless Congress extends the provision.⁷

Nondiscrimination and Key Employees

A 401(h) account cannot favor officers, shareholders, supervisory employees, or highly compensated employees in either coverage or benefit levels. The IRS tests discrimination by looking at the retirement side and the medical benefit side together, so a plan that passes on its pension benefits can still fail if the 401(h) piece skews toward the top of the pay scale.³ When testing fails, highly compensated employees who received disproportionate benefits may have to include a portion in taxable income.

Key employees get their own layer of rules. A key employee is anyone who, during the current or any prior plan year in which contributions were made on their behalf, met the definition in IRC Section 416(i), which generally covers officers earning above a specified compensation threshold, owners of more than 5% of the business, and owners of more than 1% earning over $150,000.¹ For each key employee, the plan has to establish and maintain a separate individual account for medical benefits, and their benefits can be paid only from that separate account. They cannot draw on the general 401(h) pool.

Why the Rules Matter

Any use of 401(h) funds for a non-health purpose is a prohibited transaction, and the consequences reach beyond the transaction itself. Because the 401(h) is part of the underlying pension plan, a compliance failure on the medical account can jeopardize the tax-qualified status of the entire pension.² That is the practical stake behind every rule above: the 25% test, the separate accounts, the non-diversion requirement, and the transfer conditions all protect not just the retiree health account but the pension plan it sits inside.

1
Office of the Law Revision Counsel. 26 USC 401 – Qualified Pension, Profit-Sharing, and Stock Bonus Plans
2
Internal Revenue Service. Employee Plans CPE Technical Topics – Chapter 8 IRC Section 401(h) Retiree Medical Benefits
3
eCFR. 26 CFR 1.401-14 – Inclusion of Medical Benefits for Retired Employees in Qualified Pension or Annuity Plans
4
Office of the Law Revision Counsel. 26 USC 105 – Amounts Received Under Accident and Health Plans
5
Office of the Law Revision Counsel. 26 USC 4980 – Tax on Reversion of Qualified Plan Assets to Employer
6
Internal Revenue Service. Revenue Ruling 2003-85
7
Office of the Law Revision Counsel. 26 USC 420 – Transfers of Excess Pension Assets to Retiree Health Accounts