“Can you tell me what a 401(h) plan is?”
ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings plans, including nonqualified plans. We bring Case of the Week to you to highlight the most relevant topics affecting your business. A recent call with a financial advisor from California is representative of a common inquiry related to plan types.
Highlights of Discussion
A “401(h) plan” is a retiree medical benefit account that is set up within a defined benefit pension plan to provide for the payment of benefits for sickness, accident, hospitalization and medical expenses for retired employees, their spouses and dependents if the arrangement meets the requirements of Internal Revenue Code Section (IRC §) 401(h)(1) through (h)(6) (see page 1057 of link). A 401(h) account cannot discriminate in favor of officers, shareholders, supervisory employees, or highly compensated employees with respect to coverage or with respect to contributions and benefits.
401(h) plans are appealing because contributions to fund 401(h) benefits are deductible as contributions to a qualified plan; earnings on the account remain taxed deferred; and distributions are tax-free when used for qualified health care expenses. The amount contributed to the 401(h) account may not exceed the total cost of providing the benefits, and the cost must be spread over the future service.
According to Treasury Regulation § 1.401-14(c), a qualified 401(h) account must provide for the following:
- Retiree medical benefits must be “subordinate” to the pension benefits;
- Retiree medical benefits under the plan must be maintained in a separate account within the pension trust;
- For any key employee, a separate account must also be maintained for the benefits payable to that employee (or spouse or dependents) and, generally, medical benefits payable to that employee (or spouse or dependents) may come only from that separate account;
- Employer contributions to the account must be reasonable and ascertainable;
- All contributions (within the taxable year or thereafter) to the 401(h) account must be used to pay benefits provided under the medical plan and must not be diverted to any purpose other than the providing of such benefits;
- The terms of the plan must provide that, upon the satisfaction of all liabilities under the plan to provide the retiree medical benefits, all amounts remaining in the 401(h) account must be returned to the employer.
The subordinate requirement is not satisfied unless the plan provides that the aggregate contributions for retiree medical benefits, when added to the actual contributions for life insurance under the plan, are limited to 25 percent of the total contributions made to the plan (other than contributions to fund past service credits).
Aside from employer and/or employee contributions to a 401(h) account, plan sponsors may make tax-free “qualified transfers” of excess pension assets within their defined benefit plans to related 401(h) accounts. A plan is deemed to have excess assets for this purpose if assets exceed 125 percent of the plan’s liability (IRC §420). The requirements of a qualified transfer include the following:
- The transferred amount can be used to pay medical benefits for either the year of the transfer or the year of transfer and the future transfer period (i.e., a qualified future transfer);
- The transferred amount must approximate the amount of medical expenses anticipated for the year of transfer or the year of transfer and future years during the transfer period;
- An employer can make only one such transfer in a year;
- All accrued benefits of participants in the defined benefit plan must be fully vested; and
- The employer must commit to a minimum cost requirement with respect to the medical benefits.
Pension plan sponsors may find 401(h) accounts appealing as one way to provide for the payment of retiree medical benefits. Depending on the terms of the plan, a 401(h) account can receive employer and/or employee contributions as well as transfers of excess pension benefits, provided certain requirements are met. 401(h) account contributions are tax deductible; earnings are tax-deferred; and distributions can be tax free.
 Or money purchase pension plan or annuity plan
 For qualified future transfers, substitute 120 percent