[Editor's Note: Today's guest post is by Rocco Beatrice, CPA, MBA, who also has a masters in taxation. His firm, Estate Street Partners is a team of lawyers, accountants, and business tax strategists that assists high-earners with implementing the subject of today's post- the 401(h) plan. I know, I know. Many of us have a 401(k). Some of us have a 401(a). But almost none of us have a 401(h). I hope this post will help explain what it is and who might benefit from looking more closely at it. We have no financial relationship.]
401(h) plans are one of the most powerful income tax planning tools available today. Recent changes to the Pension Protection Act have changed the landscape of qualified plan design from a contributory, regulatory, and fiduciary perspective. It is unquestionably the single-best piece of retirement planning legislation for well-compensated business-owners, partners, and the 1099 self-employed including doctors, dentists, chiropractors, etc.
The Pension Protection Act allows for individuals to create, customize, and aggregate multiple qualified plans, including the 401(h). The 401(h) combined with other qualified plan accounts create huge tax savings for highly-compensated individuals when they need it most: While in their highest income-earning years and highest tax bracket. When properly customized, contributions to these plans can exceed $1,000,000 per year while at the same time utilizing the preferred “above-the-line deduction.”
Consequently, these plans significantly reduce quarterly estimated income tax payments to IRS by up to 80%. Despite the 401(h) being the most advantageous of all qualified plan accounts, it is also the most underutilized.
A 401 Plan For Healthcare
AARP estimates that those in their 50’s today can expect medical-related costs to be around $500,000 after they retire; not including the costs of long term care. With escalating costs in healthcare, wouldn’t it be nice to set aside a tax-deductible and tax-free account to help pay these future costs? They do. It’s called a 401(h).
Unfortunately, most business-owners, the 1099 self-employed, and their CPAs are completely unaware that these plans even exist. According to recent IRS statistics, there are 1,245,000 individuals earning $500,000 or more in the U.S and most don’t take advantage of these plans. As of 2015, only 17,455 Cash Balance Plans are in existence and only approximately half of those include a 401(h). It is mind-boggling to think that less than 1% of those individuals earning $500,000 or more are utilizing the 401(h). However, these plans are 100% certified, blessed, and approved under IRC tax code.
How the 401(h) Plan Works
The 401(h) is a health expense account attached to a Cash Balance Plan. It also covers dependents including spouses, children, or parents. Unlike an HSA, these benefits get stretched to your beneficiaries after passing so your dependents can continue to take advantage of your tax-free healthcare account. As with other qualified plans, a 401(h) account is separately funded and managed. Contributions are tax deductible. Like an HSA account, the money can be triple-tax-free.
- Funded with tax-deductible money
- No taxes on capital gains or dividends as the money grows
- Allows money to come out tax-free when used for health care expenses
A doctor who transfers funds from their Cash Balance Plan and deposits them into a 401(h) is shielding those funds from taxation forever. This is one of the very few IRC provisions offering an entirely tax-free opportunity, and it is worth exploring by high-risk individuals who need asset protection and wealth preservation. Under ERISA rules, assets in qualified plans are creditor-proof. [“Creditor-proof” is not a term an attorney specializing in asset protection would use. Asset protection law is state-specific. Be familiar with the laws of your state.-ed]
401(h) Qualified Items: What is Covered?
There are over 100 approved 401(h) expenses and they include most typical health care expenses as well as some less typical expenses:
- Elective cosmetic surgery procedures
- Spa, massages, and fitness programs
- LASIK eye surgery
- Eyeglass frames
- Insurance and insurance deductibles
A frequently asked question is whether 401(h) funds can be utilized for items outside of the covered items list, and what are the potential penalties involved? To maintain complete tax-free status of 401(h) funds, you must spend the monies on the approved items list. However, you can easily transfer unused 401(h) funds back into the Cash Balance Account to purchase anything you desire, but you would have to pay ordinary income tax on funds distributed from the Cash Balance Account (not taxed when transferring from the 401(h) to the Cash Balance Account).
Once you pass on, the money in the 401(h) can still be used by your beneficiaries tax free for the same purposes.
Dr. John Barker, a 55-year old surgeon, is a partner in a practice that employs two medical assistants and a nurse practitioner. He is married and has an average income of $900,000 per year.The partnership pays Dr. Barker’s company, Barker PLLC. Living in California, he is faced with a top federal income tax rate of 39.6% and state income tax of 11%, for a total of 50.6%. He pays himself w-2 income of $110,000 and pays a FICA tax of around $20,000. As a small business owner, Dr. Parks can use his PLLC to establish a qualified plan including 401k, Profit Share, Cash Balance, 401(h), and Pre-COLA Accounts.
Being 55 years old, married, and having income of $900,000 per year, the pension actuary calculates that he can contribute a maximum of $750,000 per year. He has chosen to contribute $600,000 to his aggregated qualified plans. $143,000 of which is being contributed to his 401(h).
Effectively, he has reduced his annual income tax by about $283,000 or $70,750 every quarter. By informing the IRS of his future intention to contribute $600,000 to his qualified plans for the current tax year, he won’t actually need to make any cash outlays until September of the following year!
Dr. Barker contributed $600,000 to his retirement plan, only costing him $317,000 to do it. The remaining contribution of $283,000 was redirected from the IRS and CA Department of Revenue to his own qualified retirement accounts. That’s right, instead of sending the IRS his income tax payments, he kept the money and funded his retirement accounts.
Because he did not max-out his contributions as determined by the pension actuary of $750,000, the additional $150,000 that he did not contribute creates a carry-forward. Next year he will have the option to contribute as little as he wants or the full $750,000 plus the $150,000 carry-forward not used in the prior year, for a total potential contribution of $900,000 if he desires.
If he works 10 more years and does not use his full maximum contributions as he did in the first year, he will accumulate a carry-forward of $1,500,000. Upon retirement Dr. Barker may want to sell his practice and he can actually use the $1,500,000 carry-forward against his capital gains on the sale of his practice, potentially saving $556,500 in capital gains taxes (at maximum California tax rates.)
At age 65, Dr. Barker retires. Using funds from his 401(h), he gets some cosmetic surgery for himself and his wife, pays his annual gym membership, medical insurance, copays on doctor and dental visits. His wife also takes advantage of several 401(h) benefits including hiring a personal trainer, weight loss specialist, and even enjoys a massage every week.
Unfortunately, his dad had fallen ill and was forced to go into a nursing home facility. Dr. Barker utilizes his 401(h) funds to pay for his father’s care. He then begins taking distributions of $150,000 per year out of his Cash Balance Plan for his daily living expenses. Because he is in a much lower tax bracket, he only pays approximately $24,000 in taxes annually.
In summary, in the final 10 years of Dr. Barker’s career, he created $7,900,000 in qualified retirement accounts based on his $600,000 annual contributions at an average rate of return of 6%. $1.8M of the $7.9M will never have any income tax burden on the distribution of these 401(h) funds. In the process, he saved a total of $3.39M in total taxes; $2.83M in income taxes and $556,500 in capital gains taxes. It cost him $51,000 to set up and maintain this plan over the same 10-year period. This is a return on investment of over 650% by simply utilizing the IRC tax code to your advantage.
[Editor's Note: In case it isn't obvious to the reader, this case study, although nearly identical to an actual client of the post's author, is very different from the average doctor. Not only is this doc making $900K (4 times the average physician income), but while living in a high-cost of living area wants to save 2/3 of his gross income late in his career. The benefits to a more typical physician would be significantly more limited.]
How to Create a 401(h)
Creating a 401(h) is relatively simple. Start with your accountant or CPA. Ask him for guidance on how to create these customized qualified plans including the 401(h). Experienced CPAs typically have a pension actuary resource. If your CPA is not as familiar with this type of planning, you are welcome to have your CPA call us, and we will get him up-to-speed so that he’s better equipped to help you.
Once you have a competent pension actuary, they will ask questions about the company that you are involved with, your earnings, your age, your marital status, your employees (if any), and any critical goals or needs that you may have. (e.g. Maximize my tax deductions, maximize my 401(h), considering selling my practice in 5-10 years, or accelerate a retirement plan.)
With this basic information, the actuary will produce a report based on his calculations of your maximum contributions. Here’s an example of a workbook a pension actuary will typically put together for you:
Your CPA should be able to utilize the actuary’s numbers and formulate your plan based on your needs. Remember, these are just maximum contribution levels and are not required in any given year. Any amount below the maximum annual contribution can be used as a “catch-up” the following year if desired with a carry-forward that gets created.
In the example above, Dr. Smith will have the opportunity to contribute up to $681,982 in the first year if he chooses to maximize his benefit. The $681,982 is the amount of money being aggregated to several qualified accounts, where $73,847 is contributed to his 401(h) account. In this case, Steven Smith is the business owner and he has 10 employees that will get some of the benefit, but he will retain 93.33% of the plan benefits. If you have no employees, you will get 100% of the benefit like in the example below:
One of the amazing benefits of creating a customized qualified plan is the accelerated max contribution levels versus using an off-the-shelf 401(k) or profit share plan where only $59,000 ($54K in 2017 if under 50) can be contributed to a plan in any given year. The maximum contributions to customized qualified plans are based primarily on age, income, and marital status. When you customize a plan, the maximum contribution could exceed $1,000,000 per year.
The maximum amount that can be contributed to a 401(h) is directly related to the amount that is funded into a customized Cash Balance Plan. The maximum contribution to a 401(h) account is 33% of the total funds contributed to the Cash Balance Plan. For example, if one were to contribute $400,000 to a Cash Balance Plan, the maximum contribution allowed to your 401(h) is $100,000 and the remaining balance of $300,000 would sit in the Cash Balance Plan.
401(h) vs. Health Savings Account
Both the 401(h) and a Health Savings Account (HSA) are advantageous tools to help fund your healthcare, medical, and insurance costs on a pretax basis. The advantages of an HSA include lower costs and use prior to retirement. A 401(h) is designed for post-retirement (age 62 as defined by the plan.) However, the major difference between the HSA and the 401(h) is the maximum contribution allowed for each account.
As mentioned above, the maximum annual contribution to a 401(h) is 33% of the total funds contributed to a Cash Balance Plan. To cite the example above, if one were to contribute $400,000 to a Cash Balance Plan, the maximum contribution allowed to your 401(h) is $100,000. i.e. 300,000 CBP and $100,000 401(h).
The maximum annual contribution to an HSA account for 2017 is $3,400 if single and $6,750 for families. One can contribute an additional $1,000 per year if you are 55 years or older. Unfortunately, HSA accounts are designed to cover your existing year’s medical expenses, but does not address the potential costs for your post-retirement needs. If you don't start maxing out an HSA when you are healthy and young, the current limits on an HSA account substantially limit your ability to save money for post-retirement medical needs.
After one passes, the 401(h) and its benefits can be stretched or passed on to your dependents. If one is fortunate enough to have remaining funds in their HSA, they don’t have the option to pass the benefits to their heirs. Leftover HSA money is taxable income to the heir in the year it is inherited.
Setup and Maintenance Costs
When creating custom qualified plans, it is difficult to paint a broad brush with estimated costs. Some professionals charge as much as $10,000-20,000 for the initial set up and anywhere from $5,000 to $15,000 per year for its annual maintenance. Unfortunately, many of these professionals writing these overpriced plans do not include the 401(h) or Pre-COLA accounts – experience matters.
Our highly-experienced actuary generally charges between $5,000-10,000 for setup and design, and around $4,000-8,000 to maintain and certify each year. When setting up a doctor group, the plans cost can be shared amongst the doctors in the group. Again, the costs will vary based on the design of the plan and the number of its participants. The actuary certifies your plan every year, so you can plan with confidence. Any good pension actuary should have multiple favorable determination letters to this fact. The IRS depends on the actuary’s annual certification to confirm that your plan is in compliance with the rules/laws of the IRC code.
When the doctor retires, the 401(h) account is converted into a maintenance-free account which no longer requires an actuary’s certification each year. Therefore, the costs associated with maintaining the 401(h) account goes away. Then you can simply utilize a check book or debit card to pay for your acceptable healthcare-related items.
There is no significant reporting required, other than filing the 5500EZ form each year, the same form that needs to be filled out with an individual 401(k) larger than $250K. This form is straight forward and only takes a few moments to fill out and file. It only asks your name, the plan name, SSN, EIN, and the amount of funds maintained in the account. Make sure to keep receipts for all expenses that you pay throughout the year with this account.
[Editor's Note: Okay, we're getting into the nitty-gritty now. As you can see, the expenses associated with creating and maintaining this account are not insignificant. While they may make sense if you are making huge contributions, they're not going to make sense for smaller contributions. If you are only contributing $50K a year for 10 years to the defined benefit plan, the fees could be as much as $90K for your $500K contribution. So who is the ideal candidate here? Think of a highly-paid older doc with no or few employees and not much retirement savings yet but who really wants to save like crazy for the next 5 or 10 years. This hypothetical ideal candidate can minimize the effect of the fees and most benefit from the upsides of a cash balance plan with a 401(h).]
Every plan is required to be certified by an actuary annually. Generally, if you have employees, then you’d likely want to set up a top-heavy plan that receives 90-95% of the plans benefit. Many times, if a doctor is a partner of a group, it can be set up so they get 100% of the benefit.
Instead of creating a safe harbor where the employer is required to contribute, the actuary can create an employee carveout and create an incentive plan. For example, you can customize the plan to reward your best employees. In addition, the rewards to your employees vest over a set period of time, so if the employee leaves early, they lose the benefit. Once again, this can be customized by the actuary.
These qualified plans can be invested in mutual funds, stocks, and bonds. As the employer, just as you can choose the investments that go into a 401(k)/profit sharing plan, so can you choose the investments that go into your defined benefit plan.
Improved Business Cash Flows
One of the biggest cash flow outlays for a business is income taxes. The IRS requires to be paid every 3 months based on a quarterly estimate of your earnings for the year. The 401(h) and these qualified plans significantly reduce your quarterly estimated payments. The contributions can potentially be delayed until you are ready to write a check. The absolute deadline for making your contributions is September 15th of the following year! That is an extra 15-18 months of time and additional cash on hand to run your practice.
If you are fortunate enough to retire early, you don’t need to wait until you are 62 in order to begin distributions on these retirement accounts. These plans are extremely flexible. If for example, a doctor retires at 55, he can ask the actuary to “annuitize the plan” and begin receiving payments immediately based on his life expectancy and amounts held within the plan.
[Editor's Note: It is always fun to learn about a new type of tax-protected account. A cash balance plan can do wonders for the right person. If you're going to have a cash balance plan for your business, you might as well look at including a 401(h) option with it. But be aware that a cash balance plan with or without a 401(h) is not the no-brainer that an HSA, Backdoor Roth IRA, or individual 401(k) is. Due to the higher costs, they only really make sense for someone looking to put a lot of money away for retirement.]
What do you think? Do you have a cash balance plan? How much do you contribute to it each year? Do you have a 401(h)? Have you ever even heard of one? How much do you expect to spend on health care after age 62? Comment below!