[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.
Case Study
The Actor Playing Dr. Barker Today
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:
Maximum Contributions
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).]
Employee Contributions
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.
Investment Options
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.
Early Retirement
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!
Hey Rocco,
Thanks for the post. I really wish the tax code would offer more options to employed physicians with W2 income to save for retirement. The best options these days for employees is a 403/401+ 457 allowing a total of 36k (18+18). Compared with some of the options for physicians with income as 1099 with a solo 401k, SEP IRA and this plan 401h. Isn’t this the same thing as a defined benefit plan? Any advice for what else employed physicians can do to shelter income from IRS and save for retirement?
Hello Duke,
Yes, this is a defined benefit plan. Yes, there are other options outside the scope of this strategy/article to reduce your income taxes.
Doctors in your situation have potential options:
1. Your group/current employer can implement a cash balance and 401(h) plan parallel to your existing retirement plan. Group cash balance plans help reduce the individual cost of their set up and maintenance. For example if it costs $10,000 to set up the plan for 15 doctors, that is only $667 each for setup, and an annual maintenance of $8,000 ($533 each).
2. Some clients have changed their employment relationship to a 1099 status versus a w-2. Obviously, not everyone has this option, but some have been able to do it.
Hello Rocco ,
If you transfer 1/3 to 401h ,are you still responsible for interest crediting rate for whole amount or just 2/3 of remaining Cash Balance plan-so you can have more aggressive asset allocation on a 401h side?
If you terminate your Cash Balance plan ,can you transfer funds from 401h to IRA or 401k ?
Thanks.
Hello Alex,
The interest-crediting method is an old school approach to cash balance plans. With our actuary’s cash balance plans, you can avoid the interest-crediting method altogether and your allocations can be as aggressive as you desire with both your cash balance and 401(h) accounts.
Yes, when terminating your cash balance plan, you can transfer your 401(h) into another separately managed, maintenance-free account.
What’s the separately managed account it goes into? Is it still a health care account or just an IRA?
Rocco replied via email:
That comment was written by my assistant that was helping me out while I was in a meeting and it is not entirely correct.
This is using the interest-crediting method in a different way through plan design.
401(h) will be the only account that will not roll over into a IRA. It stays inside the trust but no longer requires annual review by the actuary therefore there won’t be an annual maintenance fee.
Are contributions to 401h discretionary like defined contribution plans or mandatory? Is employer still responsible for underperformance of 401h ? and if not , can you fund underfunded Cash Balance plan from 401h? Thank you
Contributions to CB plans and 401(h) are discretionary in our plan design. These plans are extremely flexible and if you choose to not contribute in a given year, you can catch up the following year(s) with a carry forward. The employer is not responsible for under-performance in our design. Typically we are not creating these plans for the rank and file employees, just the owners or key employees.
Rocco, if you think the IRS will let you make contributions only for owners and not for employees, you are misunderstanding a great many things. That only works if a company doesn’t have any employees or if the plan is combined with another plan for nondiscrimination testing. However, there is always nondiscrimination testing for benefits, rights, and features of a plan. So there is no possible way you could give 401(h) contributions only to the owners if the employees aren’t getting them as well. You should discuss that recent comment with your actuary first and be careful about giving out tax advice regarding matters on which you are not qualified.
Charlie,
When I said “Typically we are not creating these plans for the rank and file employees, just the owners or key employees.” I never said the rank and file employees get nothing. But with our plan design we typically achieve 85-95% efficiency rating meaning that 85-95% of all contributions/benefits going to the owners/partners/key employees.
We have been in business for over 30 years. We have many favorable determination letters from the IRS regarding CB plans, as well as an A+ with the BBB. No plan has ever been penalized or unwound that involved us or our actuary.
It is not a good idea to set the crediting rate to be a return on investment. In fact, ‘old school’ is still the best approach for group practice CB plans. Having high volatility in a group CB plan is a good recipe for disaster given the dynamics of group practices. Many are absorbed by larger ones or by the hospital, or simply disband. Then there is the issue of multiple partners retiring early and taking significant portion of the assets out. There is absolutely no reason to using aggressive investment strategies in such plans, as this would significantly increase the risk of asset liquidation under unfavorable conditions, resulting in potential losses for the plan which plan sponsor would then have to make up.
Great article–I had never heard of this. My wife and I are a dual-physician W-2 couple, placing us in the 39.6% tax bracket. I also have side 1099 income from moonlighting of around $120K. I have just been doing a SEP-IRA with the 1099 income, maxing it out each year. I am wondering if it makes sense for me to set up a cash-balance plan and 401(h), given the added complexity and up-front and maintenance costs involved? Is there a “rule of thumb” threshold for when it makes sense to go this route? A SEP-IRA is a lot simpler but much more limited in contributions etc.
Not worth the costs for 120k of side income. Keep in mind you would need to pay yourself a salary with the DB plan equivalent to the benefit so you couldn’t even put all 120k into it.
Technically you don’t need to pay yourself a salary, but the amount you can contribute to a DB plan would be lower with 1099 income vs. having the same W2. Unless your net is north of $400k (1099), no benefit in doing a CB plan especially if you are younger. For someone older you might be able to do it with a lower net, but you still want a net above $300k or so.
Also, SEP IRA does not work with DB plans, but in any case you would be better off doing a solo 401k instead of a SEP, as this allows a higher contribution with a lower net, and if both of you participate, you can make a significant contribution into just the 401k plan alone.
Plus the SEP-IRA screws up your backdoor Roth IRA. In general you want to do a solo 401(k) instead of a SEP-IRA for that reason. Whether or not you add on a DB/CBP with or without a 401(h) is a totally different issue.
It would except I transfer the entire SEP balance to my W-2 employer 401(k) plan prior to Dec 31 to avoid the pro-rata rule. I already max-out the 401(k) with 5% match so in my 401(k) I end up with 18K + 15K match + (about) 22K incoming from the SEP transfer per year = about $55K going into tax-deferred each year. Which isn’t bad and requires minimal time/effort…I probably should just stay the course and not mess with this plan. I use this calculator: http://www.sepira.com/calculator.html The DBP limit is higher but again there’s the cost/hassle factor.
Why would you want to pay taxes on the harvest (growth on your 401(k)) when you can pay taxes on the seed (your contributions) and enjoy tax free growth AND tax free distributions in retirement? Just wondering.
That’s a silly argument. It’s about the tax rates, not the total amount of tax paid. It’s about what’s left after tax, not the total amount of tax paid. Otherwise, no one would ever use a tax-deferred account because they’d be an idiot to do so.
Paul,
Thanks for the kind words.
Yes, there are other options outside the scope of this strategy/article to reduce your income taxes.
Doctors in your situation have potential options:
1. Your group/current employer can implement a cash balance and 401(h) plan parallel to your existing retirement plan. Group cash balance plans help reduce the individual cost of their set up and maintenance. For example if it costs $10,000 to set up the plan for 15 doctors, that is only $667 each for setup, and an annual maintenance of $8,000 ($533 each).
2. Some clients have changed their employment relationship to a 1099 status versus a w-2. Obviously, not everyone has this option, but some have been able to do it.
Plan design is crucial when setting up these plans. Off-the-shelf/boiler plate plans don’t provide the most desirable outcomes. It’s important to work with a top-notch actuary.
The plan can be designed to include only the partners, key employees and/or doctors depending on the goals you have.
Thanks Rocco.
If a group already has a good cash balance plan, what would be the estimated cost to add and maintain a 401(h).
If the CB plan is pool invested, can the 401h be separately managed by the participant?
Hello Gipper,
Our actuary would have to review your plan to quote you a cost. We’d be happy to do that for you for free.
If your CB plan is pool invested, then your 401(h) is also pool invested, but it would be a different account and could provide different investments than the original pool.
I think the biggest obstacle would be having the multispecialty clinic I work for (about 70 docs, 550 employees total) even consider a cash balance/pension plan. I would say the majority of doctors here make under $500k/yr so that would also offer no incentive to change for them. We currently have a 401k set up and I am sure the partners don’t want to have the burden of a guaranteed yearly pension to retired employees (much like most of corporate America since pensions are now a rarity being offered). Is there any option setting up something like a 401(h) without requiring a cash balance plan?
“In a traditional DB plan, the benefit is defined at the normal retirement age and is guaranteed by the plan sponsor. In a cash balance plan, the benefit is defined as the actuarial equivalent of an accumulation of contributions and earnings and that amount is guaranteed by the plan sponsor.”
https://www.cashbalanceactuaries.com/cash-balance-vs.-defined-benefit-plans
A CB plan is not nearly as risky as the traditional DB plans, especially if the assets are managed conservatively.
However, adding a CB plan might be more cost effective for the practice than doing profit sharing, because you can exclude a lot more staff than with a profit sharing design, so the benefit might justify the cost. Without a thorough study it is impossible to say whether a CB plan would work for a group as large as yours.
Hello Xrayvsn,
A 401(h) is attached a CB plan, so you cannot have a 401(h) without the CB plan.
The income cutoff will vary depending on state income taxes, but the general rule of thumb is a minimum of $300,000 per year of income.
With a group as large as yours, I would be surprised to hear that they wouldn’t be interested in saving several million dollars a year on their income taxes. Just the potential FICA tax savings for the group could be pretty substantial in itself.
It can be set up to avoid the burden of a guaranteed yearly pension to retired employees. Plan design is crucial when setting up these plans. Off-the-shelf/boiler plate plans don’t provide the most desirable outcomes. It’s important to work with a top-notch actuary.
The plan can be designed to include only the partners, key employees and/or doctors depending on the goals you have.
We are currently working with a doctors group in Texas (no state income tax) with 14 partners making between $400,000 – $500,000 with a total of 30 employees. This group saved $4,000,000 in income taxes their first year and will save $2,000,000 every year thereafter.
We’d be happy to take a look at creating a customized plan for your group based on their goals. There is no cost or obligation for a review and design proposal.
Thank you so much for the response. I passed it along to our pension committee (which I am a member of) as well as the CFO, who read the article and is interested and wrote back to me saying he will get in touch with you. Our practice is located in TN (also without state income tax like your TX example).
I do have a follow up question. Based on your article it looks like a company can have a traditional 401k and a cash balance plan with 401(h) option. Is that correct? And what are the advantages/disadvantages of doing a combined offering like that? As I mentioned we currently have a 401k plan and do profit sharing. I am assuming that can continue to go on (with both current and future investments) and that this may be offered where some of the doctors may take advantage of it while others may not (and not get penalized financially with the annual fees). Definitely an eye opening article and love the potential tax savings mentioned.
Absolutely, a company can have a traditional 401k and a cash balance plan with 401(h) option. Many clients ask us to create a 401k parallel to the CB plan. They can all be maxed out every year if you so desire. Your company can keep their existing 401k if they choose or we can review it to see if it can be improved or maintained for a lower cost.
I wish some thing like this existed for CMEs. Where you can put pretax money (like 30-50k) into an account, use it for legal CME trips and whatever is unused you get back at the end of the year after paying taxes on the remaining monies
Your group can set up a business and medical reimbursement plan to avoid tax, which would include CMEs.
That’s exactly how it works for the self-employed. You just deduct whatever you spend on CME. If you’re an employee, try to talk your employer into offering a CME account as a benefit. Most academics and many other employed docs have them.
Can one have an HSA account and a 401h at the same time?
Yes, you can utilize both at the same time.
Our group is in the process of setting up a cash balance plan. If we implemented this in addition to the cash balance plan do you think it would still add the 10-15k expenses a year?
Also since we have employees and they do not participate in the cash balance plan would adding this plan affect the discrimination testing? Thank you for the article.
The cost would include the CB plan, a profit share plan, and a 401(h) plan. If your current provider does not offer the 401(h), you may want to consider getting a second opinion.
Plan design is crucial when setting up these plans. Off-the-shelf/boiler plate plans don’t provide the most desirable outcomes. It’s important to work with a top-notch actuary.
The plan can be designed to include only the partners, key employees and/or doctors depending on the goals you have.
We’d be happy to take a look at creating a customized plan for your group based on their goals. There is no cost or obligation for a review and design proposal.
WCI, I know you say the tax code makes no sense, but I’m struggling to understand the rationale for the existence of a plan like this for very high earners in a country that supposedly has a progressive tax system. Someone like Dr. Barker would cleary have more money using this plan than paying the typical tax rate for someone with his high income, but what societal purpose does it serve for someone like that to get a tax break so he has more money for cosmetic surgery in retirement for he and his family (or for any healthcare for that matter)? You could ask the same question of other aspects of the tax code like carried interest for example, but I really don’t see the broader purpose for this type of plan.
First, the tax code neither makes sense, nor is it fair. As my daughter noted in her guest post a few months go, life isn’t fair and the sooner you realize that and try to make it unfair in your behalf, the better off you will be.
Second, all tax breaks are tax breaks for the rich because the rich are the ones that pay taxes.
Third, despite all these tax breaks, the code is still quite progressive. In 2007 I paid < 5% of my income in taxes while I was in the 15% federal and 0% state brackets. As my income has climbed through the rest of the brackets and is now in the top bracket, I paid 32% this year. Even with all the breaks, high earners are still paying a higher percentage of their income and a dramatically higher total tax burden than low earners. Fourth, I have no idea what the "societal purpose" is for most tax breaks. I don't try to justify them. I just try to learn them and use the ones that seem useful to me. 529s have a great societal purpose "to help people go to college" but when you look at who is actually using these things in any significant way to save on taxes, it's a who's who of the 1% club. The mortgage interest deduction is really only beneficial to a very small percentage of homeowners. Most charitable deductions don't lower taxes because the donators took the standard deduction anyway.
Sure, life is unfair and on some level you just have to accept that. But you shouldn’t necessarily just shrug your shoulders and move on when you encounter something that you find unfair even if you can figure out how to tilt the odds in your favor. In this case, we are essentially talking about your pain and mine for paying a high level of income taxes versus the societal need for the government to be funded and to pay debt obligations. People will disagree about how to strike that balance with government taxes and spending, but these legislators have to do something each year with taxes and spending and to some extent it will come down to what they feel is fair to the different constituencies involved. If you choose to vote you can have some small amount of say in such decisions.
While tax breaks disproportionately benefit the rich since the rich pay more in taxes due to their high incomes, I don’t think it’s true that all tax breaks are for the rich. What about the earned income tax credit for low wage earners? Maybe that’s not a tax break, but it seems like one.
Like you, I now pay way more and a much higher percentage of income in taxes than I did a decade ago. In 2016 my effective federal tax rate was 33.5% as someone with a high W2 income. So for you and me the tax code has indeed been quite progressive. While I feel your same pain about paying so much money in income taxes, it doesn’t seem right that Warren Buffett pays a lower percentage of income tax than his secretary if the tax system is supposed to really be progressive. Based on Warren Buffet’s example and the issue I brought up for people who can take advantage of the carried interest loophole, it seems to me that the tax system is progressive for people with a high W2 income, but not necessarily for those who have a really high income who can structure their income to be delivered in ways that are favored by the tax code like earning a lot of money through capital gains or being compensated with carried interest. While I realize that even if people with incomes 10x or 100x mine all paid a similar percentage of tax that I do that it wouldn’t make that much difference in tax collections b/c there just aren’t that people with that high of an income, I would hope that such a change might make everyone else a little less cynical about the tax system, inequality, etc.
On some level the tax code ought to serve a purpose to encourage people to do what the government wants them to do like save for college education, buy a house, get married, save for retirement, etc. So I can see that ostensible purpose with the 529 plan and the mortgage interest deduction to follow-up on your examples even if the net-effect is just to funnel more money to people like you and me with a lot of money to save who can also afford to purchase expensive houses. People will disagree on whether the tax breaks from the mortgage interest deduction and 529 plans are fair on account of the tilt towards those with a high income, but these rules could be changed to be less beneficial to those with high incomes. However, this rule for 401(h) plans doesn’t seem to have any higher purpose other than to provide a tax break for those with a high income. Maybe I shouldn’t care, but as someone who does pay a lot of tax I do.
Fair enough, since income taxes can be negative thanks to the EIC, that is a tax break for the poor.
I agree carried interest is bogus. But given that both parties think it’s bogus, it’s kind of a mystery why it is still in the tax code.
I agree you are better off structuring your income as something besides W-2 earned income. That’s just called playing by the rules of the game. There are good reasons dividends and capital gains are taxed at lower rates. There are good reasons not to pay payroll taxes on business profits.
I disagree that the tax code ought to serve any purpose other than fund the necessary functions of government in the most efficient manner possible. The tax code isn’t the place for social engineering. We can do that with the spending budget more efficiently I think.
But hey, this is all in the realm of politics because reasonable people can disagree on the best thing to do.
If you think the 401(h) rule is bogus and you want to do something about it, I would recommend calling your Congressman and maybe it can be removed in the upcoming tax reform. Or perhaps write a letter to the editor of the NYT or something.
But I wouldn’t feel guilty about using it while it is in place even if you don’t think it’s fair. As Judge Learned Hand said,
Oh that’s interesting that you think the tax code should strive to “fund the necessary functions of government in the most efficient manner possible.” That actually seems like a totally reasonable goal.
It seems like the tax code as currently structured doesn’t achieve the behavioral changes that are being sought (for example, getting people to sign up for health insurance or contribute to their retirement accounts). Maybe that’s just b/c using the tax code this way is inherently ineffective or it just reflects the fact there are too many competing interests in tax law for tax policy to have any consistent impact on what people do or don’t do? It is definitely complex enough that it is hard to figure out all the ways you can save money on taxes and I appreciate your efforts as WCI to point out these various opportunities.
I suppose I had mistaken your other comments on the blog related to trying to figure how to tilt the tax code in your favor (contributing to tax deferred retirement accounts, 529 contributions, etc) as an endorsement of using the tax code as a tool to nudge people towards behaviors that the government wants you to do, but I guess you were just making the point that these are good ways to lower your taxes and increase your chances of saving enough for retirement and/or college and not really commenting on whether or not that is good policy.
And I don’t think people should feel guilty about using something like a 401(h) plan. I agree that you may as well take advantage of tax benefits that are there for the taking. But I suspect many of these wrinkles in the tax code are there b/c the people who benefit from them agitated to get that benefit legislated in the first place and/or lobby to keep to it that way, which is certainly within your rights as a citizen, but somewhat different than just taking advantage of some aspect of the tax code.
Can’t say I disagree with any of that.
Rocco, you should have your actuary check IRC section 415(l) and 415(c) because the design you are showing in your first example seems to violate those code sections. No person can be allocated more than $54,000 of employer money in 2017 to a qualified defined contribution plan.
Any money that goes into 401(h), reduces the profit sharing maximum. That is one reason people aren’t sponsoring these plans. Also, plan sponsors need to understand that by adding 401(h) they are committing to taking an annuity distribution and sponsoring the plan for a long time, rather than a lump sum and terminating their cash balance plan. That’s the reason our clients choose to avoid 401(h). They don’t want to be locked into the actuarial fees that go with having a cash balance plan when they are no longer making contributions to it. It eats up most of the small tax savings they might get by putting $20k into 401(h) each year.
Charlie , if you have NHCE and total employer contributions do not exceed 31% under both plans (401k and cash balance )you are not limited to 6% to Profit sharing plan ?
Yes Alex, that is true. You are allowed to deduct the greater of the CB contribution plus a 6% profit sharing or 31% of payroll. That is not the problem with the example used in this article. The problem is that the sum total of each person’s 401(k) deferral, profit sharing, and 401(h) contribution cannot be above $54,000. It’s not a deductibility issue, it’s a maximum allocation issue. When a doctor maximizes his or her 401(k) and profit sharing contributions, there is no room for any 401(h) contributions.
This is distinctly different from what is being advocated by Rocco. Can one of your cite chapter and verse to support your position?
Sure, IRC Section 415(l) and 415(c).
Rocco isn’t arguing with the fact that the cap is $54k per year. He is actually talking to doctors who are capped at $34,200 per year for deduction reasons because they don’t have any employees. Those doctors seem to be the only ones who might benefit from 401(h) for an additional $19,800 deduction.
For doctors who can put in the whole $54k, you would have to forego profit sharing to do 401(h). And in my experience, none of our clients ever choose to do this.
I don’t see any reason why they would.
It’s been a while since I edited this post, but in the back and forth before publication, my impression was it was possible to defer hundreds of thousands into a cash balance plan and 1/3 of that could be in a 401(h). With the $54K limitation, it’s not quite pointless, but it’s pretty darn close.
I apologize if there was any confusion pre-publication.
Not really when you consider the flexibility of the 401h.
401h Pro’s:
1. Flexibility of a carry-forward
2. Income tax superiority – never pay taxes on 401h funds
3. Ability to put back un-needed 401h funds to the cash balance account if desired
4. Pay for healthcare for you, your spouse, and all other dependents
5. Stretch the account upon death to your dependents
401h Con’s:
1. Funds can only be used for healthcare-related expenses in retirement
Ultimately, it needs to make sense for the one considering the plan. After all, as fiduciaries, we’re just trying to do what in the best interest of our client. What makes sense for you may not make sense for someone else to achieve their goals or meet their needs.
401h Con’s:
1. Funds can only be used for healthcare-related expenses in retirement
2. Reduces your profit-sharing contribution dollar for dollar
That second one is a pretty big con considering the additional expenses of a CBP/401(h).
You would rather spend $1000 to set up a 401k that can only be contributed $18K to and ultimately have to pay taxes on upon distribution than pay $500 for a 401h that is never taxed in your lifetime and has up to a $54K limit on?
No, what I’m saying is that if I’m putting $54K into a 401(k)/Profit-sharing plan already, it’s a lot harder to get excited about the cost and hassle of setting up a DBP in order to get a 401(h) that reduces the PSP contribution dollar for dollar. My initial understanding was that you could dump another $200K or whatever into a DBP in addition to the $54K into the 401(k) and $60K of that DBP contribution could go into a 401(h). That’s huge for the right person.
The 1/3 of the cash balance is a cafeteria plan allowance. The owner uses it to fund retiree medical up to the PS cap and/or life insurance. I’d say 95% of the owners I’ve seen buy life insurance and CARRY FORWARD the 401(h) allowance which is ideally funded with proceeds of the sale of the company to reduce capital gains.
Yes, the carry forward seems to be a key part of the strategy.
Charlie,
I believe that you are referring the double up in tax year 1 of $83,360? You are correct, one cannot exceed $54,000 in any Defined Contribution plan year. However, this example illustrates the plan year ending on November 30th, 2016 and a new plan year begins December 1, 2016.
The example is only contributing $41,680 in each plan year ($41,680 x 2 = $83,360).
Often, we find actuaries will typically use scare tactics because they are not able to offer the same level of expertise in regards to the 401(h).
Adding a 401(h) does NOT commit a sponsor to take annuity distribution what-so-ever. The 401(h) account gets utilized as medical expenses get incurred in retirement.
Upon retirement, the money in the 401(h) stays in the trust until the time which it is used for medical expenses, while the CB plan can get rolled over into an IRA. At this point, the trust no longer is required to get an actuarial approval, cutting the actuarial fees and maintenance costs to potentially ZERO ($0) for the 401(h); Some actuaries will charge clients to maintain the 401h even if there is no work or maintenance required. We do NOT.
The only requirement is the 5500 EZ which can be filed in less than 30 minutes once a year without the need of an actuary – if you want our actuary to file the 5500 EZ they charge a flat $500 per year, but you or your CPA can file this at no cost. Upon death the account gets passed on to your dependents (stretched) for their continued use.
Our design is specifically designed for small business owners and the cost/benefit is usually so overwhelming that 99.9% of our clients choose to add on the 401h to their CB plan.
The marginal cost of including the 401(h) is $500 when one gets the CB plan and Profit sharing plan. typically, a total cost for a single business owner with no employees, including the 401(h), is $5-7K to set up and $4-7K to maintain all of the accounts, reporting, and actuary’s annual certification of the plans is included. Cost will vary depending on the complexity of the case and the number of employees.
We have been in business for over 30 years and our actuary for more than 40 years. We have many favorable determination letters from the IRS regarding CB plans and 401(h)’s, as well as an A+ with the BBB.
No plan has ever been penalized or unwound that involved us or our actuary. If you would feel comfortable with your own favorable determination letter from the IRS, one can be gotten for $3500.
1. To reiterate, the 401(h) is $500 additional for the setup and legal documentation, and then $500 additional annually for the administration. So not a huge add-on cost.
2. The first point that this person makes about the 6% cap on professional service companies is exactly the reason we started using the 401(h), as our actuary would say, “to level the playing field”.
3. The main reason people don’t use the 401(h) is because they have never heard of it. In fact, we just wrapped up a company audit for a client, and the IRS agent had no idea what the 401(h) was either. In fact, he tried to disallow the deduction. We responded with, “you should probably get one of the actuaries/attorneys in your retirement division at the IRS involved”, and he came back a couple days later and approves everything.
So bottom line, we are not forcing anything on anyone. We are offering additional benefits that other firms aren’t. They don’t have to use it.
So the $54K limit includes both the 401(k)/profit-sharing contribution and the 401(h)? That kind of defeats the purpose (deferring tons of money) doesn’t it?
Hi Rocco, are you sure no Schedule SB is required after retirement assets have been rolled out? The plan isn’t terminated. Can you point me to something that says a Schedule SB is required for an ongoing CB plan? I can’t find anything that wouldn’t require it.
It’s not that I’m afraid of offering 401(h) in our cash balance plans, I just haven’t found the benefits for clients with it yet. If you can convince me, I’ll be happy to offer the service. Your article is certainly interesting, it just seems like there are a lot of hoops to jump through. And that’s probably why it costs $5k-$7k to set up for a 1 person company and $4k-$7k per year. A regular cash balance plan for a one person company should be about $2k-$3k to set up and $2k-$3k per year to run.
For plans where the doctors can maximize profit sharing contributions, I highly doubt any of the doctors would choose 401(h) over profit sharing. So I’m assuming you are only talking about owner-only companies with no employees, right? Your article seems to indicate it’s a good idea for all companies, but I can’t imagine that being the case.
If we assume a single-owner with no employees, you are talking about an additional $19,800 per year of tax deduction into the 401(h). If it truly only costs $500 per year, that might be worth it. But with the option to make after-tax employee contributions and then convert them to Roth money with that $19,800 for no additional cost, that is the option our clients have chosen instead of the hassle of 401(h).
One more question, do you have a volume submitter plan document that includes 401(h) or will these have to remain on individually designed plan documents?
Thanks for your time.
Yes, we are 100% sure that Schedule SB is not required, as the Plan terminates, but not the Trust. The Schedule SB is the actuarial certification that the Cash Balance retirement benefit is properly funded to the standard of the law. Once the retirement side is terminated and distributed, the actuary no longer has to certify that portion is funded properly.
The cost estimates we provided include a 401k/Solo K, profit share, Cash Balance, 401h, and pre-COLA accounts. Not everyone desires or chooses to have a 401k/Solo K, Profit Share, or 401h so the costs could be a little less depending on the needs of the owner. Especially with the Solo K and Profit Share when only one trust is needed for the DB plan instead of 2 trusts.
Everyone’s situation is different regarding which account they want to max out. Some may prefer to fund their 401h over their 401k/Solo K and profit share for the superior tax treatment, carry-forward, flexibility, stretch benefit, and their perception of what they feel they and their dependents may need for healthcare in retirement.
Most clients we work with want to fund a 401h before a profit share or 401k/Solo K because of its flexibility and tax superiority. The 401k/Solo K and profit share require ordinary income taxes be paid upon distributions versus no income taxes on distributions from the 401h. Plus the 401h has the flexibility to role it back into the cash balance account if so desired. 401k/Solo K don’t allow for a carry forward and there are no benefits to use the funds for healthcare or any other use.
401h Pro’s:
1. Flexibility of a carry-forward
2. Income tax superiority – never pay taxes on 401h funds
3. Ability to put back un-needed 401h funds to the cash balance account if desired
4. Pay for healthcare for you, your spouse, and all other dependents
5. Stretch the account upon death to your dependents
401h Con’s:
1. Funds can only be used for healthcare-related expenses in retirement
Our designs are ideal for small businesses typically 1-15 employees, but also advantageous for larger businesses as well. The design will vary depending on the size, complexity and needs of the owners.
As for the question about the volume submitter document, there isn’t even a volume submitter document for Cash Balance Plans yet. You can get a volume submitter document for a traditional vanilla Defined Benefit Plan, but that is it at this point. So the 401(h) is not available as a volume submitter. However, we have a number of Favorable Determination Letters including our 401(h) addendum, and we have been through company audits using the 401(h), and have had no issues.
Rocco, the IRS is reviewing volume submitter cash balance plan documents right now. Are they reviewing documents with 401(h) provisions? My assumption is that they are not and you will always need an individually designed document for 401(h). Your shifty answering of the questions is what is making me nervous. I don’t doubt that you can and do get determination letters on the plans. The question is simply whether or not all of the hassle and expense is worth it or not.
Last question, have you been through an audit of a trust after plan termination? Rev. Rul. 69-157, 1969-1 C.B. 115, provides that a trust that is part of a qualified plan will not retain its qualified status after the plan has been terminated. Rev. Rul. 69-157 also provides that a plan is not considered terminated in fact where the plan continues in effect until all the assets have been distributed to participants in accordance with the terms of the plan.
It seems to me that a cash balance plan cannot terminate and keep the 401(h) trust as a qualified trust. Do you have any legal backup to what happens with the 401(h) money after the plan terminates? I couldn’t find anything in my research. Everything I see says the 401(h) has to be part of the CB plan. Once the CB plan goes away, the 401(h) has to go with it. Please provide a site to the contrary.
This is where this whole thing falls. I spoke with an ERISA attorney and he said in no uncertain terms that the trust will have to terminate very shortly after the termination of the plan, so it might last a year or two, but if it stays around for longer the IRS can have a problem with it.
Given how rare these plans are, there is probably not a lot of precedent, so prior to attempting this, you would need a written opinion from an ERISA attorney (who is independent from the seller). You might have to find an attorney who has experience with these plans, too, but without a very strong letter (near certainty), I would not get anywhere near this.
The 401(h) is only one option for folks planning for healthcare expenses in retirement. Ultimately, a well-informed person setting up a qualified plan, will determine if the benefits outweigh the costs/”hassle” to help them achieve their goals.
It’s important to work with an experienced actuary from start (set up and accumulation) to finish (distribution and plan closing).
In your article and comments you never mentioned the two pitfalls that make 401h all but useless for most of the small practice and group plans:
1) The fact that it reduces your profit-sharing contribution dollar for dollar
2) Funds have to be distributed on termination (defeating the whole purpose of using this for medical expenses). So unless you are running a CB plan in perpetuity, a 401h is not very useful.
Most actuaries would agree that these criteria make such plans all but impractical for 99% of their clients.
Kon,
# 2) Is incorrect and inaccurate,
It’s important to work with an experienced actuary from start (set up and accumulation) to finish (distribution and plan closing).
According to a nationally recognized ERISA attorney, #2 is correct, and quite accurate. An actuary is not an attorney.
Before anyone gets excited about 401h plans, please read below, this is an assessment from an actuary I specifically asked to comment on this type of plan, since I have no bone to pick, and I’m curious as to whether this would work for our clients. This is what he wrote:
“401(h) contributions still count as annual additions under section 415. So for a plan sponsor who is already maxing 401(k) and profit sharing, there is no room to make a 401(h) contribution. For someone who can’t deduct additional profit sharing because of the 6% deduction limit, they might be tempted by 401(h), but the problem is that those clients don’t want to continue sponsoring a cash balance plan once they retire. The costs of doing that offsets any savings the business owner could get from the extra 7% of pay they could put into a 401(h) plan.
The company that is pushing these via the article you sent is going to have a lot of unhappy clients down the road once they figure out what they’ve got. But I wish our clients did 401(h) plans as it would guarantee they would remain clients for a long time rather than terminating their plans and rolling the money into an IRA. Unfortunately, I have yet to find a client where such a plan makes sense. There are plenty of reasons people don’t use 401(h) as an option in their CBPs and I don’t think it’s because of any new legislation that people simply don’t know about. The main reason is that companies don’t want to sponsor CBPs forever. And the secondary reason is that business owners want to maximize profit sharing money before money that can only be used to pay medical expenses.
However, the idea that it isn’t ever taxed is interesting. If a company was committed to sponsoring a CBP forever for some reason, then maybe it would make sense to forego profit sharing and make 401(h) contributions instead. But I doubt there any of our clients in that boat.”
We disagree about your statement regarding the complexity of the 401h and would argue that is it pretty simple to fund and maintain. In fact, it offers you a whole lot more flexibility than the 401k/Solo K and Profit share. Ultimately, it’s really what the client/owner wants to accomplish. After all, as fiduciaries, we’re just trying to do what in the best interest of our client.
401h Pro’s:
1. Flexibility of a carry-forward
2. Income tax superiority – never pay taxes on 401h funds
3. Ability to put back un-needed 401h funds to the cash balance account if desired
4. Pay for healthcare for you, your spouse, and all other dependents
5. Stretch the account upon death to your dependents
401h Con’s:
1. Funds can only be used for healthcare-related expenses in retirement
Often, we find actuaries, lawyers and financial professionals will typically use scare tactics because they are not able to offer the same level of expertise in regards to the 401(h). Our actuary has been doing this for 40 years so there more than a thousand clients that have already begun their retirement/distribution phase and they could not be more thankful.
Adding a 401(h) does NOT commit a sponsor to take annuity distribution what-so-ever. The 401(h) account gets utilized as medical expenses get incurred in retirement.
Upon retirement, the money in the 401(h) stays in the trust until the time which it is used for medical expenses, while the CB plan can get rolled over into an IRA. At this point, the trust no longer is required to get an actuarial approval, cutting the actuarial fees and maintenance costs to potentially ZERO ($0) for the 401(h); Some actuaries will charge clients to maintain the 401h even if there is no work or maintenance required. We do NOT.
The only requirement is the 5500 EZ which can be filed in less than 30 minutes once a year without the need of an actuary – if you want our actuary to file the 5500 EZ they charge a flat $500 per year, but you or your CPA can file this at no cost. Upon death the account gets passed on to your dependents (stretched) for their continued use.
Our design is specifically designed for small business owners and the cost/benefit is usually so overwhelming that 99.9% of our clients choose to add on the 401h to their CB plan.
The marginal cost of including the 401(h) is $500 when one gets the CB plan and Profit sharing plan. typically, a total cost for a single business owner with no employees, including the Solo K/401k, Profit Share, Cash Balance Plan, Pre-COLA, and 401(h), is $5-7K to set up and $4-7K to maintain all of the accounts, reporting, and actuary’s annual certification of the plans is included. Cost will vary depending on the complexity of the case and the number of employees.
We have been in business for over 30 years and our actuary for more than 40 years. We have many favorable determination letters from the IRS regarding CB plans and 401(h)’s, as well as an A+ with the BBB.
No plan has ever been penalized or unwound that involved us or our actuary. If you would feel comfortable with your own favorable determination letter from the IRS, one can be gotten for $3500.
1. To reiterate, the 401(h) is $500 additional for the setup and legal documentation, and then $500 additional annually for the administration. So not a huge add-on cost.
2. The first point that this person makes about the 6% cap on professional service companies is exactly the reason we started using the 401(h), as our actuary would say, “to level the playing field”.
3. The main reason people don’t use the 401(h) is because they have never heard of it. In fact, we just wrapped up a company audit for a client, and the IRS agent had no idea what the 401(h) was either. In fact, he tried to disallow the deduction. We responded with, “you should probably get one of the actuaries/attorneys in your retirement division at the IRS involved”, and he came back a couple days later and approves everything.
So bottom line, we are not forcing anything on anyone. We are offering additional benefits that other firms aren’t. They don’t have to use it.
401h cons:
1) Reduces your profit-sharing contribution dollar for dollar
2) Funds have to be distributed on termination (defeating the whole purpose of using this for medical expenses). So unless you are running a CB plan in perpetuity, this is not very useful.
It’s important to work with an experienced actuary from start (set up and accumulation) to finish (distribution and plan closing).
Here’s my personal assessment of 401h plans. I’ve spoken to several actuaries and an ERISA attorney, and the following is my take on whether a 401h plan has a place for a small medical or dental practice.
While all of this sounds great on paper, the problem with 401h plans is really the level of complexity and degree of compliance support that is necessary to make these plans work (which will most definitely lead to significant increase in cost beyond what’s stated). According an ERISA attorney I consulted, such plans will not be a good idea for smaller practices (for there reasons stated in my post above), though they might work for very large ones. In addition, there are still a number of outstanding issues with such plans:
http://www.groom.com/media/publication/1747_Current%20Issues%20Affecting%20Pension%20Plan%20401_h_%20Accounts.pdf
So I would not recommend starting a plan like that without an ERISA attorney on retainer, and I would also suggest that you contract your own TPA/actuary about this plan first. If you add this to your existing combo plan, there cannot be two cooks – you need to have your actuary/TPA oversee the compliance and administration of this plan, you can’t have someone else do it because the job of making sure that all of the parts are compliant will be nearly impossible without good communication and full understanding of all of the parts.
With retirement plans (especially for small practices that don’t have the luxury of having an attorney and/or HR staff) it is never a good idea to have plans with significant complexity to achieve a simple goal. If you want to save for retirement – great, there are low cost vehicles that can be serviced by a good number of compliance experts (including TPAs and actuaries). I believe that in the near future we’ll have access to potentially expanded HSA accounts for all, so accumulating significant tax-free assets for healthcare would be possible on an individual level (and also on a group plan level as well). There are too many moving parts to 401h plans, and the stated cost is likely only a small part of the cost one would have to pay to keep this going.
If you really want to look into adding a 401h plan, I would recommend doing an independent cost-benefit analysis that also includes advantages and disadvantages, rather than just the advantages, and I would suggest using an independent ERISA attorney or an actuary to make this determination, rather than trust the company that’s trying to sell you something. So always get a second opinion, whether from an ERISA attorney or your own actuary before considering this type of plan.
Also, remember one thing: such complex plans are sold as products, and those are rarely done by fiduciaries working in your best interest. And ask yourself: if this is such a great plan, why isn’t everyone using one? It is almost always a bad idea to create hybrid solutions (that are in aggregate more complex and more expensive) to solve problems for which two simple solutions can be found instead, so for that reason I would not recommend such plans (unless your ERISA attorney or an actuary thinks it’s a great idea, however, just make sure they don’t recommend this to you because they see it as an endless supply of revenue for themselves due to all of the complexity).
I am a big fan of using whatever the tax code allows to reduce ones taxes.
However, i am also a fan of getting the govt to eliminate the most egregious loopholes. This is but one example. In general shifting pay to business income to avoid fica is another huge one. Others include various charitable easements, and trusts. Even our president got to take a huge write off on losses that were forgiven by the banks (so they were not real).
When the common people complain about how washington (where i live) is set up to favor the rich, while the middle class keeps getting shafted, this type of set up is what they mean.
As i said, i advocate taking what the law allows, but in a just and fair society writing off 3/4 of a million dollar income when that type of thing is not abailable to the middle class is just not right.
Surprised you have a problem with S Corp structure. A certain amount of owning a business is earned income- meaning you work for it. Another part is the risk of your capital. As long as you don’t have to pay FICA on your index fund dividends and capital gains I don’t see why you should have to pay it on some portion of your small business profits.
The issue is not the legitimate shifting where the business income is legitimately much more than the salary.
In the guest post example, a 900k surgeon was taking 100k in w2 income. That does. It represent the earnings of his invested capital but rather shows shifting what would be his/her salary to non salary income.
This is what most small business owners do. They optimize for social security bend points and not getting challenged by the IRS. But they don’t take a salary (and pay tax on )that is reflective of what they would earn if they were an employee.
Do you think a senior surgeon employed by a large practice or hospital would only make 100k?
No, I agree $100K is too low. The IRS probably would too.
This is a question for his CPA. The actuary works with what the CPA and owner gives him.
What will happen with the account if you are retired and plan is terminated ? or not retired , but sell your practice and terminate your 401k/CB plan ? Does it need to go back to Cash Balance plan for distribution and you would end up with years of payment for account that you can not use ?Thanks.
It would have to be closed/distributed within a short period of time. This is the opinion of my ERISA attorney. And I would get an ERISA attorney’s opinion letter regarding that. And you might also want to get your actuary’s opinion on that as well. Without legal certainty, this aspect breaks the whole deal.
I don’t know guys. After reading the comment section I’m spooked. I’m filing this in the too complex and not worth the hastle file for me at this point. I get the triple tax benefit and inheritable aspect, but I just dont know if I’ll need much more than what I’m saving in my HSA for health and related qualifying expenses and there are other tools available for high level estate planning if that becomes necessary.
Especially if the HSA contribution limit doubles.
If you already maxed out a defined benefit plan are you still able to have one of these accounts? If not, is there another way to put away money tax free besides the small amount you can put in a 401k?
Possibly. We would need to review your specific situation to see if you are maximizing your qualified plan. We’d be happy to look at it with you if you would like.
Not unless you have another unrelated business and can open another 401k/DB plan.
Via email, some feedback about 401(h) plans from a doc who sought out his pension person who sought out an actuary:
From the pension guy:
We had our actuary dig into the 401h plans in more detail. There must have been an article recently published about it, because we had another client ask us about it last week as well. While nice in theory due to the fact that the money is never taxed, it’s really not a practicle solution unless you have an owner-only plan, or a are very large employer that can carry the costs of maintaining this complex arrangement.
Basically, the arrangements let you put money in a pension plan to be used for medical expenses that are not covered by insurance (or Medicare). They can only be used after you are age 62. The funds go in tax free, grow tax free, and come out tax free provided they are used for medical expenses. BUT, see the caveats below. We don’t know of any firms that actually administer these.
A more practical solution may be for a client to fund an HSA every year (if they have a high deductible health plan). You basically get all of the same tax advantages, without the complexity. And if you fund it during your employed years and save it for retirement, you could potentially accrue a significant amount.
From the actuary:
“They are barely used in small plans because they are quite impractical. Issues:
If the plan adds this feature, the participant has to keep the plan around until they reaches age 62, and then beyond that until the 401(h) account is depleted. This forces them to maintain the plan long beyond when it would normally serve any other useful purpose to them and they’d have ongoing annual fees well into the future.
The maximum annual contribution a participant can make towards the 401(h) account is treated as part of the normal PS plan annual addition limit (even though its contributed towards the 401(h) account in the DB plan. We then further need to make sure that on a cumulative basis the 401(h) contributions don’t exceeds 25% of the cumulative DB contributions.
The amount to be contributed to the 401(h) accounts must be actuarially determined to provide the specific post-retirement health benefits provided by the plan – this requires a separate and much more complicated annual actuarial valuation, which will double the annual fees you currently pay for the plan.
The plan document will need to be restated off a current mass submitter volume submitter document to an individually designed document to include these 401(h) account provisions as the IRS does not allow these account provisions in any pre-approved plan documents. This will substantially increase the cost of maintaining the plan document. Furthermore the IRS will no longer accept submission of individually designed plans, so we can never have assurance that the plan is qualified unless and until the plan is audited.
So all in all, I don’t see this as a practical option – it exposes the client to lots and lots of extra fees well into the future. These accounts, when used, are usually used for large plans, but even then are fairly rare.”
As the only person on this blog (other than the author) who has actually read the trust document in question and seen 10-20 actual illustrations for our advisory clients, I can tell you that pretty much every one of these posts is manure.
So much wasted time talking about why tax-free Viagra when the owner retires! …As Carville would say, “it’s about the life insurance, dummy”.
The 401(h), along with life insurance and a few others, is a DB incidental benefit. This is not a 412(i) plans or any other non-IRS tested design but Google “Why Would I Include Life Insurance In My Qualified Retirement Plan?“ and “HOW TO CORRECT AN OVERFUNDED DEFINED BENEFIT PLAN“ to learn about the subject.
The testing group goes into the retiree medical that vests when they retire from that company (it’s a bookkeeping entry). As 401(h) is a DB allocation, there are ZERO non-owners in the cash balance, so you can throw away all those silly Kravits cash balance fund brochures and invest in pretty much anything ERISA will allow. The owners group use the 1/3 cash balance overfunding to buy life insurance with pre-tax dollars. The retiree medical allowance they do not use is CARRIED FORWARD. When they sell the company, sale proceeds fund the $200-400k accrued 401(h) to reduce the capital gains. Employees are terminated and hired by the buyer, the plan is dissolved, the life insurance goes to an ILET, the cash balance goes to an IRA, and yes, the actuary collects medical receipts to allow triple tax-free deductions on Viagra in the owners’ 401(h) accounts. Staff 401(h) allowances are de minimus and as stated, very few vest. The TPA cost is about $8k/year and the 401(h) administration is gratis.
I am a humble advisor and what I’ve described is certainly not close to being 100% accurate …but it’s far more accurate than what I’m reading from the me-too/Sunguard cash balance calculator crowd. So PLEASE do not waste your time researching why this beats your little mousetrap.
Oh, do you mean this?
https://www.irs.gov/pub/irs-tege/chap801.pdf
I am studying this Plan and may pursue a marketing opportunity to appropriate markets.
Can you recharacterize or transfer money from your 401k into 401h plan?
I’m not sure. I know you can roll money in there from a defined benefit plan, so maybe you can do it from a defined contribution plan. I’d just check with whoever offers your 401h.
I have a doctor that is making over $500k/yr, had a cash balance but closed it because it was over funded, can he reopen the cash balance plan and open a 401h plan to be able to contribute to both plans. He still has about $15k left of the excess that he is paying off so that can go into the 401h if he is able to open the 401h, correct? Can you please call me at 352-369-0014 as I have other questions about the 401h plan as well as other doctors and CPAs that will be interested in this plan, thank you.
I’m not sure who you’re hoping will answer your question and give you a call, but this post was written 4 years ago, there are only 13 people subscribed to it, and not one of them is the author of the piece.
I don’t know the answer to your question nor will I be calling you. I’d suggest reaching out to the author at his website.
I answered the question and set him up with the actuary who struck the deductions cited in the (four year old) post! See: front9admin.com Great tool in the right hands and these are the guys.
Read your long post dated November 2,2017 and trying to get my head wrapped aroubd it, Let m know if its possible to directly contact you, Thanks
Hey Dr.
Happy to arrange a call with you, your CPA, and the pension actuary who certifies these deductions. In preparation, I am available at 904/710-6899 to discuss the structure. I’m a healthcare consultant down the I-95 in Jacksonville who does some pension work around 401(h).
Mike Smith