Key Takeaways
- Employer-paid premiums are generally tax-deductible to the employer and tax-free to employees.
- Section 125 cafeteria plans allow pre-tax employee contributions.
- COBRA premiums are paid with after-tax dollars by former employees.
- Disability benefit taxation depends on who paid the premium.
- Non-discrimination rules limit preferential treatment for key employees.
- Employer tax treatment varies for fully insured vs. self-funded plans.
Employer-Provided Health Insurance
Employer-provided health insurance receives favorable tax treatment that makes it one of the most valuable employee benefits. Both employers and employees benefit from the tax advantages.
Employee Tax Treatment
Exclusion from Income
| Component | Tax Status |
|---|---|
| Employer-paid premiums | Excluded from employee's income |
| Pre-tax employee contributions | Reduces taxable income |
| Health benefits received | Tax-free |
What's Excluded
| Item | Excluded? |
|---|---|
| Medical insurance premiums | Yes |
| Dental insurance premiums | Yes |
| Vision insurance premiums | Yes |
| Short-term disability premiums | Yes |
| Long-term disability premiums | Yes (but affects benefit taxation) |
| Group term life (up to $50,000) | Yes |
Key Point: Employer-paid health insurance premiums are excluded from the employee's taxable income for federal income tax, Social Security tax (FICA), and state income tax (in most states).
Payroll Tax Implications
| Tax | Treatment of Employer Health Premiums |
|---|---|
| Federal income tax | Excluded |
| Social Security (FICA) | Excluded |
| Medicare tax | Excluded |
| State income tax | Usually excluded |
| FUTA (employer) | Excluded |
Employer Tax Treatment
Business Deduction
| Feature | Details |
|---|---|
| Deductibility | 100% deductible as business expense |
| When deductible | Year premiums are paid |
| Type | Ordinary and necessary business expense |
| No dollar limit | Full amount deductible |
Employer Requirements
| Requirement | Details |
|---|---|
| Non-discrimination | Must not favor highly compensated employees |
| Coverage rules | Must offer uniformly to eligible employees |
| ERISA compliance | Subject to federal ERISA rules |
| ACA requirements | Applicable large employers face mandates |
Section 125 Cafeteria Plans
How Cafeteria Plans Work
| Feature | Details |
|---|---|
| IRS Code section | Section 125 |
| Also called | Flexible benefit plans |
| Purpose | Allow pre-tax payment for benefits |
| Participation | Employee chooses from menu of benefits |
Pre-Tax Benefits Available
| Benefit | Pre-Tax Under 125? |
|---|---|
| Health insurance premiums | Yes |
| Dental/vision insurance | Yes |
| Dependent care assistance | Yes |
| HSA contributions | Yes |
| Health FSA | Yes |
| Cash (salary) | Yes (taxable option) |
Annual Enrollment
| Requirement | Details |
|---|---|
| Election period | Usually once per year |
| Irrevocable | Cannot change mid-year without qualifying event |
| Qualifying events | Marriage, birth, divorce, job change |
| Documentation | Required for mid-year changes |
Exam Tip: Section 125 elections are irrevocable for the plan year. Employees can only change their elections if they experience a qualifying life event (marriage, birth, loss of other coverage, etc.).
COBRA Taxation
Premium Tax Treatment
| Aspect | Tax Treatment |
|---|---|
| COBRA premiums paid | Generally after-tax |
| Premiums for self-employed | May be deductible as self-employed insurance |
| Employer subsidies | Taxable income to former employee |
| Benefits received | Tax-free |
COBRA Premium Assistance
| Situation | Tax Treatment |
|---|---|
| Employer subsidy of COBRA | Taxable to individual |
| ARP COBRA subsidy (2021) | Tax-free |
| State premium assistance | Varies by program |
Disability Insurance Taxation
Premium vs. Benefit Taxation Trade-off
| Who Pays Premium | Premium Tax Treatment | Benefit Tax Treatment |
|---|---|---|
| Employer | Excluded from income | Benefits fully taxable |
| Employee (after-tax) | No deduction | Benefits tax-free |
| Split (employer/employee) | Proportional | Proportional taxation |
Planning Implications
| Strategy | Result |
|---|---|
| Employer pays all | Higher net benefit but taxable |
| Employee pays all | Lower net cost, tax-free benefits |
| Split arrangement | Balance of both |
Key Point: With disability insurance, there's a trade-off. If the employer pays premiums (tax-free to employee), benefits are taxable. If the employee pays with after-tax dollars, benefits are tax-free. Many advisors recommend employee-paid to ensure tax-free benefits when needed.
Non-Discrimination Requirements
ACA Non-Discrimination Rules
| Rule | Requirement |
|---|---|
| Eligibility | Cannot favor highly compensated employees |
| Benefits | Same benefits for all eligible employees |
| Contributions | Employer contribution must be fair |
| Waiting periods | Maximum 90 days for all employees |
Self-Insured Plans
| Requirement | Details |
|---|---|
| Eligibility test | 70% of all employees or 80% of eligible |
| Benefits test | Same benefits for all participants |
| Concentration test | Key employees ≤ 25% of benefits |
Consequences of Discrimination
| Violation | Result |
|---|---|
| Insured plans | Excise tax (currently not enforced) |
| Self-insured plans | Excess benefits taxable to HCEs |
| Cafeteria plans | Benefits taxable to key employees |
Key Takeaways
- Employer-paid premiums are generally tax-deductible to the employer and tax-free to employees.
- Section 125 cafeteria plans allow pre-tax employee contributions.
- COBRA premiums are paid with after-tax dollars by former employees.
- Disability benefit taxation depends on who paid the premium.
- Non-discrimination rules limit preferential treatment for key employees.
- Employer tax treatment varies for fully insured vs. self-funded plans.
How are employer-paid health insurance premiums treated for tax purposes for the employee?
An employer pays the full premium for an employee's long-term disability insurance. How are the disability benefits taxed if the employee becomes disabled?
What allows employees to pay health insurance premiums with pre-tax dollars through payroll deduction?