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Secure tax-free health perks in retirement with a 401(h) plan

by on
in Small Business Tax

All the talk about health care reform may have you thinking: How can you pay for ever-rising medical expenses when you’re no longer working? Even a sizable pension can be quickly drained.

One practical solution seems to have flown under the radar.

Strategy: Set up a Section 401(h) plan. This little-noticed arrangement pays for costs associated with the sickness, accident, hospitalization and medical expenses of retired employees, their spouses and their dependents.

Distributions used for qualified purposes are completely tax-free to plan participants. This can enable you to save tens of thousands of dollars over time.

Here’s the whole story:
Small business owners can prepare for the future by establishing a qualified retirement plan. For example, you may have started a defined benefit plan, like a traditional pension plan, years ago. As with other qualified plans, the pension plan is subject to tax-law limits. For 2010, contributions to the plan may fund a maximum annual benefit of $195,000 (the same as 2009).

But, if you incur heavy medical expenses in retirement, there is generally little or no tax payoff. That’s because medical expenses are deductible only to the extent the annual total exceeds 7.5% of your adjusted gross income (AGI). For example, if you have an annual AGI of $200,000 in retirement and you’re hit with $10,000 in unreimbursed medical expenses in one year, no medical deduction is allowed. Reason: Your medical expenses do not exceed the threshold of $15,000 (7.5% of $200,000).

By adding a Section 401(h) plan to the defined benefit plan arrangement, you may provide incidental health benefits for your family in retirement in a tax-smart fashion. The contributions are tax deductible like regular defined benefit contributions. Caveat: The incidental health benefits can’t cost more than 25% of the employer’s total contributions to the defined benefit plan.

When you use the funds in a 401(h) account to pay for qualified medical expenses, no tax is due on the distributions. This could result in substantial savings.

Example: Suppose you own a small dental practice with five full-time employees of varying ages and compensation. You’ve been funding your own defined benefit plan with $80,000 of contributions a year (plus making the contributions required for the other employees). Assume that you will remain in the 35% tax bracket in retirement.

For simplicity, let’s say you average $10,000 in annual unreimbursed medical expenses in the first 10 years of retirement. In the usual case, you will need to use $15,384 of your pension payout to cover the $10,000 in medical expenses each year when you figure in the 35% tax rate ($15,384 x 0.65 = $10,000 left after taxes).

Better approach:
Instead of contributing the entire $80,000 to your regular retirement account, you allocate $10,000 a year to a 401(h) account for the 10 years prior to your retirement. Now compare what happens.

For starters, there is no tax on the $10,000 annual distribution to pay for medical expenses. Thus, you save $5,384 a year by using a 401(h) plan, or a total of $53,840 over 10 years. Furthermore, you can generate even more savings with the continuous tax-deferred buildup of funds in your account.  

The Section 401(h) plan must meet certain tax-law requirements for distributions to qualify for tax-free treatment (see box below).

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