12.4 Section 125 / Cafeteria Plans and Self-Funding
Key Takeaways
- Employer group medical premiums are deductible to the employer and not taxable to the employee; medical benefits received are tax-free.
- For disability income, taxation flips on who paid: employer-paid premiums make benefits taxable; employee after-tax premiums make benefits tax-free.
- Section 125 cafeteria plans let employees choose among a taxable option (cash) and pre-tax qualified benefits like FSAs.
- Health FSAs follow the uniform coverage rule (full election available day one) and use-it-or-lose-it, with an optional carryover OR grace period, not both.
- Self-funded plans put claim risk on the employer, are governed by ERISA (exempt from state mandates), and use specific and aggregate stop-loss for protection.
Section 125 / Cafeteria Plans and Self-Funding
This section covers how employer health benefits are funded and taxed. The exam tests the tax treatment of employer and employee contributions, the mechanics of cafeteria plans (Section 125) and flexible spending accounts (FSAs), and the difference between fully insured and self-funded plans.
Taxation of Group Health Contributions
The general rule for group medical expense insurance:
| Item | Tax Treatment |
|---|---|
| Employer premium contributions | Tax-deductible to the employer; not taxable income to the employee |
| Employee contributions (via Section 125) | Paid with pre-tax dollars |
| Benefits received (medical expense reimbursement) | Not taxable to the employee |
Contrast with disability income insurance: if the employer pays the premium (and does not include it in income), the benefits are taxable to the employee; if the employee pays with after-tax dollars, benefits are tax-free. This 'who-paid-the-premium' rule is a classic trap — but medical expense benefits are tax-free regardless.
Section 125 Cafeteria Plans
A Section 125 cafeteria plan lets employees choose among qualified benefits using pre-tax dollars. The menu must include at least one taxable option (usually cash) and at least one qualified pre-tax (nontaxable) benefit. Choosing cash makes it taxable; choosing benefits keeps it pre-tax.
Common components:
- Premium-only plan (POP) — lets employees pay their share of group premiums pre-tax.
- Health FSA — employees set aside pre-tax dollars for out-of-pocket medical costs. The 2026 IRS contribution limit is approximately $3,300 (rounded; verify the current year's figure).
- Dependent care FSA — pre-tax dollars for childcare, capped at $5,000 per household.
The 'Use-It-or-Lose-It' Rule and Worked Example
An employee elects $2,400 for the year in a health FSA, contributing $200/month. Under the uniform coverage rule, the full $2,400 is available on day one of the plan year, even though only $200 has been deducted. Under use-it-or-lose-it, unspent funds are forfeited at year-end — though plans may offer a carryover (about $660 for 2026) or a 2.5-month grace period, but not both.
Fully Insured vs. Self-Funded Plans
How the employer bears claim risk is the final tested distinction.
| Feature | Fully Insured | Self-Funded (Self-Insured) |
|---|---|---|
| Who bears claim risk | The insurer | The employer |
| Premium / funding | Fixed premium to insurer | Employer pays claims as incurred |
| Regulation | State insurance law | Primarily ERISA (federal), state-exempt |
| Best for | Small/medium employers | Large employers with cash flow |
| Risk protection | N/A | Stop-loss insurance |
In a self-funded plan, the employer pays claims directly from its own funds and assumes the risk. To cap exposure, employers buy stop-loss insurance:
- Specific (individual) stop-loss — reimburses claims for any one person above an attachment point (e.g., $50,000).
- Aggregate stop-loss — reimburses total claims above a threshold (e.g., 125% of expected).
Because self-funded plans are governed primarily by ERISA, they are generally exempt from state mandates — a heavily tested point. An Administrative Services Only (ASO) arrangement lets a self-funded employer hire an insurer to process claims without transferring risk.
An employee elects $2,400 in a health FSA for the year, with $200 deducted monthly. In February the employee incurs $2,000 of qualified medical expenses. How much can be reimbursed at that time?
A large employer pays its employees' health claims directly from company funds and purchases coverage that reimburses any single claim exceeding $75,000. This arrangement is best described as:
Health Savings Accounts and HDHPs
A related employer-benefit structure is the Health Savings Account (HSA), which must be paired with a qualified High-Deductible Health Plan (HDHP). Unlike an FSA, HSA funds roll over indefinitely and are owned by the employee — they travel with the worker after leaving the job.
- For 2026, an HDHP must have a minimum deductible of roughly $1,700 self-only / $3,400 family (verify current IRS figures).
- HSA contributions are tax-deductible (or pre-tax through payroll), grow tax-free, and withdrawals for qualified medical expenses are tax-free — a 'triple tax advantage.'
- A person enrolled in Medicare cannot contribute to an HSA.
Exam Tip: FSA = use-it-or-lose-it, employer-owned, no HDHP required. HSA = rolls over, employee-owned, requires an HDHP.
Tying Funding to Regulation
The funding choice drives which law governs the plan. Fully insured plans are regulated as insurance under state law and must include state-mandated benefits. Self-funded plans are employee benefit plans governed by ERISA, a federal law that preempts most state insurance regulation — so a self-funded employer can design benefits without complying with each state's mandates.
Decision Summary
| If the question mentions... | The answer points to... |
|---|---|
| Employer pays fixed premium, insurer bears risk | Fully insured (state-regulated) |
| Employer pays claims, buys stop-loss | Self-funded (ERISA, state-exempt) |
| Insurer only processes claims, no risk transfer | ASO arrangement |
| One person's claims above an attachment point | Specific stop-loss |
| Total claims above a threshold | Aggregate stop-loss |
FSA vs. HSA vs. HRA — Don't Confuse Them
Three employer account types appear on the exam, and the test loves to swap their attributes. A Health Reimbursement Arrangement (HRA) is funded solely by the employer, reimburses qualified medical expenses, and (unlike an FSA) the employer decides whether unused amounts carry over. An FSA is funded mainly by employee pre-tax salary reductions and is use-it-or-lose-it. An HSA is owned by the employee, requires an HDHP, and rolls over indefinitely.
| Account | Funded By | Rollover | Requires HDHP | Owner |
|---|---|---|---|---|
| FSA | Employee (pre-tax) | No (limited carryover) | No | Employer |
| HSA | Employee/employer | Yes, unlimited | Yes | Employee |
| HRA | Employer only | Employer's choice | No | Employer |
Exam Tip: If the question says 'employer-only funding,' it is an HRA. If it says 'rolls over and the employee keeps it,' it is an HSA. If it says 'use-it-or-lose-it,' it is an FSA.