The retirement plan everyone should have, but almost no one does.

Health Care costs are rising. Combined with the fact that Social Security may not be around by the time you are ready to retire means you should weigh your options carefully now.

With the rising cost of Long Term Care insurance and nursing homes, how can you pay for these expenses?

Pay as you go. Paying claims as they arise means you don’t set aside funds to pay for future liabilities. However, after years with many expensive claims, you may wonder why you didn’t set up some sort of advance funding mechanism to offset the costs.

Health Savings Accounts (HSAs)/Heath Reimbursement Accounts (HRAs). Saving money through an HSA or an HRA for medical costs is familiar to many active employees. The money that has been set aside can be used for expenses during active employment or it can be saved toward medical costs during retirement. However, the effect on the company’s bottom line tends to be neutral. Further, in this day of high insurance deductibles, how do you encourage employees to let their funds accumulate for their retirement years?

Prefunding, through a Voluntary Employee Benefits Association (VEBA). A VEBA is a trust that funds only health and welfare benefits. As a way to prefund retiree medical benefits, it has the advantage of deductibility of contributions under the Internal Revenue Code (Section 419A) and it offsets liabilities that must be reported according to Financial Accounting Standards Board (FAS Statement 106). However, income on the invested assets is taxable to the trust.

Prefunding through a Code Section 401(h) account. This is an account created through the adoption of an amendment to a company’s defined benefit or money purchase pension plan. A 401(h) account has the same advantages of a VEBA, but because it is inside a qualified plan, investment income grows tax-free. The plan (a medical expense account) pays for costs associated with sickness, accident, hospitalization, and medical expenses of retired employees (EEs) (and their spouses and dependents).

With a 401(h) plan, an employer can take a 100 percent deduction to fund a tax-free sinking fund where, when retired employees (EEs) remove money from the plan to pay for medical expenses, there are no income taxes due. The 401(h) post retirement medical option is perhaps the most overlooked and underutilized plan benefit in the industry today. The 401(h) benefit can add up to 33.33% to the otherwise maximum tax deductible contribution of your pension plan.

 

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What can I do with my 401h?

Example: Assume Mr. Smith (business owner) earns $400,000 a year (W-2) and has five employees of various ages and salaries. Mr. Smith has been funding in a tax-deferred manner $80,000 into a defined benefit plan every year. If he keeps doing this, he will ultimately have approximately $2,000,000 in the plan when he turns 65 years old. Assume that on average Mr. Smith will have $10,000 of medical expenses every year in retirement. Assume he is now and will be in the 35% income tax bracket.
How can a 401(h) plan help?

Mr. Smith could have his business fund X amount of money in a tax-deductible manner into a 401(h) plan every year as an employee benefit for himself and the other employees (discrimination testing for EE contributions is done using the classic age, years of service, and salary testing guidelines).

The money is allowed to grow tax free and can then come out tax free from the 401(h) plan if used for medical expenses (including elective surgery). Therefore, instead of funding $80,000 every year into a defined benefit plan, let’s assume he allocates $10,000 of the $80,000 to the 401(h) plan from ages 55-65.

At age 65, what is the net positive benefit of using the plan?

If we assumed a 5% rate of return in the 401(h) plan and the pension plan, the accounts would both have the same balances when Mr. Smith hits age 65: $149,171 (we are just comparing the $10,000 contribution made from ages 55-65).

Now let’s assume that Mr. Smith incurs $10,000 of medical expenses every year in retirement. When Mr. Smith uses $10,000 from his 401(h) plan, the money comes out 100% tax free. When he removes it from the defined benefit plan to pay expenses, it is 100% taxable.

How do the numbers compare?

From the 401(h) plan, he could remove $10,000 a year tax free until he turns age 90.

However, because he would have to remove $15,384 from his taxable pension plan to net $10,000 after tax, he would run out of money in this example at age 78.

Therefore, the net positive benefit to Mr. Smith when allocating $10,000 to a 401(h) plan vs. a tax-deferred plan is $127,007. This is how much more after-tax money could be removed over time using the 401(h) plan in this example.