12.4 Section 125 / Cafeteria Plans and Self-Funding

Section 125 Cafeteria Plans

A cafeteria plan (authorized under Internal Revenue Code Section 125) lets employees choose among taxable cash and a menu of qualified pre-tax benefits. The defining tax feature: amounts an employee elects toward qualified benefits are deducted before federal income and FICA taxes, lowering taxable income. To qualify, the plan must offer at least one taxable option (cash) and at least one qualified benefit.

Common qualified benefits: employer health/dental/vision premiums, group-term life up to $50,000, disability, and the funding accounts below. Deferred compensation generally cannot be offered through a Section 125 plan (the 401(k) is a narrow exception).

Why Pre-Tax Election Saves Money

The value of Section 125 is purely tax efficiency. Suppose an employee earns $4,000/month and elects $400/month of qualified benefits through a cafeteria plan. That $400 is removed from gross pay before federal income tax and the 7.65% FICA tax, so taxable wages drop to $3,600.

• If the employee's combined income-plus-FICA marginal rate is roughly 30%, the pre-tax election saves about $400 × 30% = $120/month versus paying for the same benefits with after-tax dollars.
• The trade-off: lower reported wages can slightly reduce Social Security benefit calculations and cannot be reversed mid-year except for a qualifying event.

The irrevocability rule is a frequent exam point: once an employee makes an annual cafeteria-plan election, it generally cannot be changed during the plan year unless a qualifying status change (marriage, birth, divorce, employment change) occurs. This locks the pre-tax advantage and prevents gaming the account.

FSAs, HSAs, and HRAs

The most tested distinctions: an HSA requires enrollment in a high-deductible health plan (HDHP), is owned by the employee, and rolls over year to year; an FSA is subject to use-it-or-lose-it; an HRA is funded only by the employer. Note an employee cannot make new HSA contributions once enrolled in Medicare.

Self-Funding and Stop-Loss

In a self-funded (self-insured) plan, the employer pays claims directly out of its own assets instead of buying a fully-insured group policy. The employer assumes the risk and often hires a third-party administrator (TPA) to process claims. Self-funded ERISA plans are largely exempt from state insurance mandates and premium taxes — a major reason large employers self-fund.

To cap catastrophic exposure, employers buy stop-loss insurance:

• Specific (individual) stop-loss — reimburses claims on any one member above a set attachment point (e.g., $100,000).
• Aggregate stop-loss — reimburses total plan claims above a threshold (e.g., 125% of expected claims).

Fully-insured vs. self-funded is a frequent exam contrast: in fully-insured, the insurer bears risk and state mandates apply; in self-funded, the employer bears risk and ERISA preemption applies.

Taxation of Group Benefits — Worked Points

Group benefit taxation is heavily tested. Memorize these rules:

• Group health premiums paid by the employer are deductible to the employer and not taxable income to the employee; benefits received are generally tax-free.
• Group-term life: the cost of the first $50,000 of employer-paid coverage is tax-free to the employee. Coverage above $50,000 creates imputed income taxed under the IRS Table I rates.
• Group disability income: if the employer pays the premium, benefits are taxable to the employee; if the employee pays with after-tax dollars, benefits are tax-free.

Worked example: An employer provides $90,000 of group-term life. The first $50,000 is tax-free; the cost of the remaining $40,000 is added to the employee's W-2 as imputed income using Table I. A second trap: employer-paid disability premiums = taxable benefits, which is why high earners often prefer to pay their own DI premiums with after-tax dollars to keep benefits tax-free.

HSA Contribution Mechanics and the MEC Cross-Reference

The HSA's tax treatment is a triple advantage: contributions are pre-tax (or deductible), growth is tax-deferred, and qualified medical withdrawals are tax-free. Non-qualified withdrawals before age 65 face income tax plus a 20% penalty; after 65, non-qualified withdrawals are taxed as income but escape the penalty, functioning like an IRA. To contribute, the individual must be covered by a qualifying HDHP and have no disqualifying coverage (such as a general-purpose FSA or Medicare).

A quick cross-reference candidates confuse with cafeteria-plan taxation: the MEC 7-pay test belongs to life insurance, not health. A life policy that is funded faster than a 7-year level-premium schedule becomes a Modified Endowment Contract (MEC), after which distributions are taxed LIFO (gain first) with a 10% penalty before age 59½. Do not apply the 7-pay/MEC rule to HSAs or cafeteria benefits — it is a distractor designed to test whether you can separate life-insurance taxation from employer health-plan taxation.

Worked Numeric: FSA Use-It-or-Lose-It and the Carryover

A Section 125 cafeteria plan lets employees pay for qualified benefits with pre-tax salary, cutting both income and FICA taxes. A common component is the health flexible spending account (FSA), funded by pre-tax salary reductions up to the annual IRS limit. The classic trap is the use-it-or-lose-it rule: unspent FSA funds are forfeited at year-end, though employers may offer either a limited carryover (a few hundred dollars) or a 2.5-month grace period - never both.

Example: an employee elects $2,800 to an FSA, spends $2,400, and the plan allows a $640 carryover. The employee keeps the $640 into next year and forfeits $160. Note the uniform-coverage rule: the full annual FSA election is available on day one, even before the salary reductions are fully withheld.

Self-Funding and Stop-Loss

In a self-funded (self-insured) plan the employer pays claims from its own assets and is largely exempt from state insurance mandates under ERISA preemption. Employers buy stop-loss insurance to cap exposure: specific stop-loss limits the loss on any one member, while aggregate stop-loss caps total plan claims for the year.