When it comes to retirement planning strategies for business owners, most discussions center around traditional options like 401(k)s, SEP IRAs, or defined benefit plans. However, one powerful yet underutilized tool deserves your attention: the 401(h) plan.
What Is a 401(h) Plan?
A 401(h) plan isn’t a standalone retirement account but rather a special medical benefit component that can be added to qualified defined benefit plans. This little-known option allows business owners to set aside tax-advantaged funds specifically for healthcare expenses in retirement.
The Triple Tax Advantage
The appeal of 401(h) plans lies in their remarkable tax treatment:
- Tax-deductible contributions for your business
- Tax-free growth of investments within the account
- Tax-free withdrawals when used for qualified medical expenses in retirement
Few retirement planning vehicles offer this “triple tax advantage” – making 401(h) plans worth serious consideration for profitable small business owners.
A Real-World Example: Meet Mr. Smith
To illustrate the potential benefits, let’s examine how a 401(h) plan might work for a typical business owner:
Mr. Smith owns a successful small business, earning $400,000 annually (W-2) and employing five people. He currently contributes $80,000 each year to a defined benefit plan, projecting approximately $2,000,000 in retirement savings by age 65. He expects around $10,000 in annual medical expenses during retirement and falls in the 35% tax bracket.
Instead of putting the entire $80,000 into his defined benefit plan, Mr. Smith decides to redirect $10,000 annually into a 401(h) plan from ages 55-65. Assuming a 5% return rate, both accounts would contain about $149,171 by retirement (comparing just the redirected portion).
The Dramatic Difference
Here’s where things get interesting. When Mr. Smith begins using these funds in retirement:
From the 401(h) plan:
- He can withdraw $10,000 annually completely tax-free for medical expenses
- These withdrawals could continue until age 90
From the traditional pension plan:
- He would need to withdraw $15,384 to net $10,000 after taxes (at 35%)
- His funds would be depleted by age 78
The net benefit? An additional $127,007 in after-tax wealth that can be used for healthcare costs – simply by restructuring how he saves, not how much.
Is a 401(h) Plan Right for You?
A 401(h) plan makes the most sense if:
- You own a profitable small business
- You already have or are considering a defined benefit or cash balance plan
- You want to maximize tax advantages
- You’re concerned about healthcare costs in retirement
- You’re looking for additional tax-advantaged savings beyond traditional retirement accounts
Implementation Considerations
While the benefits are substantial, 401(h) plans do require proper setup and administration:
- They must be attached to a qualified defined benefit plan
- Contributions cannot exceed 25% of the total pension plan contributions
- Proper discrimination testing must be conducted for employee contributions
- The plan requires separate accounting from the primary pension plan
The Bottom Line
In today’s landscape of rising healthcare costs and tax uncertainty, strategic retirement planning requires looking beyond conventional options. The 401(h) plan represents an opportunity for business owners to significantly enhance their retirement security while achieving immediate tax benefits.
As with any sophisticated financial strategy, consulting with knowledgeable advisors is essential to determine if a 401(h) plan aligns with your specific situation and goals. However, for many profitable small business owners, this underutilized tool may represent one of the most efficient ways to prepare for healthcare expenses in retirement.
Interested in learning whether a 401(h) plan could benefit your business? Contact our retirement planning specialists today for a complimentary consultation at 812-774-5829 or schedule an appointment online.
This article is for informational purposes only and should not be construed as tax, legal, or financial advice. Always consult with qualified professionals regarding your specific situation.