6.2 Contributory vs Noncontributory Plans

Contributory vs Noncontributory Group Plans

A central design decision in any group health plan is who pays the premium. This single choice drives participation rules, adverse selection risk, and tax treatment.

Contributory Plans

In a contributory plan, the employer and employee share the premium cost. The employee's share is typically deducted from payroll. Because employees must pay part of the cost, some healthy employees may decline — creating adverse selection risk. To counter this, insurers impose a minimum participation requirement of 75% of eligible employees. If participation falls below 75%, the insurer may refuse to issue or renew the contract.

The 75% rule is the industry standard for contributory group health (and applies similarly to group disability, group life, and other contributory group products). Employers can boost participation by raising their contribution percentage — a 90% employer contribution leaves employees with only 10% to pay, dramatically increasing take-up.

Noncontributory Plans

In a noncontributory plan, the employer pays 100% of the premium. Because there is no employee cost, there is no economic reason for an eligible employee to decline, so insurers require 100% participation — every eligible employee must be covered** — coverage is effectively 100%. Noncontributory financing is common in group life insurance (where it is often the default to secure the group rate) and is sometimes used in group health, particularly for executive carve-out plans or small, tightly held groups.

Noncontributory plans tend to be more expensive for the employer on a gross basis (no employee cost-sharing) but simpler administratively (no payroll deductions to track) and immune to participation shortfalls.

Tax Treatment of Premiums

The tax treatment of employer and employee premium payments is a frequent exam point:

• Employer's share: deductible to the employer as an ordinary and necessary business expense under IRC §162. Not taxable as wages to the employee (excluded from gross income under IRC §106).
• Employee's share: when paid through a Section 125 cafeteria plan (pre-tax premium conversion), the employee's share is excluded from gross income (pre-tax), reducing both income and FICA/OASDI taxes. Without a cafeteria plan, the employee's share would be paid with after-tax dollars.
• Tax-free benefit: employer-paid health premiums are one of the largest remaining untaxed fringe benefits in the U.S. tax code.

Section 125 Cafeteria Plans

A cafeteria plan (IRC §125) lets employees pay their share of health insurance premiums with pre-tax dollars. This reduces the employee's taxable wages — saving federal income tax, FICA, and (in most states) state income tax. The employer also saves its share of FICA on the reduced wages, which is why most employers adopt premium-only cafeteria plans (POP — Premium Only Plan) even when they offer no other flexible benefits.

Key cafeteria plan rules:

• Written plan document required; employees must have a choice between at least one permitted taxable benefit and one qualified benefit (e.g., cash vs health coverage).
• Pre-tax elections are irrevocable for the plan year unless a permitted change event (HIPAA special enrollment, marriage, birth/adoption, divorce, change in employment status) occurs.
• Uniform coverage rule: the plan cannot vary the health coverage amount during the year based on salary reduction elections (e.g., cannot increase the health premium mid-year solely to absorb more pre-tax dollars).

Adverse Selection Control

The contributory/noncontributory distinction is fundamentally an adverse selection control mechanism:

• Noncontributory: 100% participation by default → adverse selection eliminated because all risk levels enroll.
• Contributory + 75% rule: high enough participation that the healthy majority dilutes the cost of the less-healthy minority → adverse selection contained.
• Late enrollee restrictions: employees who decline initial coverage generally must wait for open enrollment or a special enrollment event — preventing "sign up when you get sick" behavior.

Employer Contribution Strategies

Common contribution designs:

• Flat percentage (e.g., 75% of premium regardless of tier) — simplest, but can make dependent coverage expensive.
• Tier-based (e.g., 90% employee-only, 70% employee + spouse, 60% family) — manages dependent cost and encourages employee-only enrollment.
• Dollar amount (e.g., $300/month toward any plan) — defined contribution style, common with ICHRA (Individual Coverage HRA) arrangements.

ACA affordability is tested against the lowest-cost self-only plan offering: for applicable large employers (50+ FTE), the employee's share for self-only coverage in the lowest-cost plan cannot exceed roughly 9.x% of household income (indexed annually; the §4980H affordability percentage for 2025 was 9.02%). Employer contributions must clear this threshold for at least one plan to avoid ACA §4980H employer-shared-responsibility penalties.

Summary of the Distinction

The exam frequently tests this distinction alongside the tax treatment of premiums and the role of cafeteria plans — be ready to combine these topics.