A §401(h) account is one of the few federal-tax vehicles that combines a current-year business deduction, tax-deferred growth, and tax-free distribution in a single structure.
Layer 1 — Current deduction
Contributions are deductible to the sponsoring business in the year paid, identical in treatment to the underlying DB plan contribution. For a C-corporation in a 21% bracket, a $75,000 §401(h) contribution offsets $15,750 of federal income tax. For a pass-through owner in the 37% bracket, the same contribution offsets $27,750.
Layer 2 — Tax-deferred growth
Investment income inside the §401(h) account is not subject to federal income tax while the assets remain in trust, identical to other qualified-plan assets.
Layer 3 — Tax-free distribution
Distributions to retirees, spouses, and dependents for qualified medical expenses are received tax-free — no inclusion in gross income, no impact on AGI, no IRMAA effect.
Effective after-tax value
A $1 of pre-tax income directed into a §401(h) effectively converts to roughly $1.50–$1.60 of after-tax medical purchasing power for a high-bracket owner compared to paying for the same medical expense out of post-tax personal income.