12.4 Section 125 / Cafeteria Plans and Self-Funding

Section 125 Cafeteria Plans

A Section 125 cafeteria plan (named for the Internal Revenue Code section) lets employees choose between taxable cash and qualified pre-tax benefits. Premiums and contributions run through payroll before income and FICA taxes are calculated, lowering taxable wages. The "cafeteria" name reflects that employees select from a menu of benefits.

Common Cafeteria Plan Components

Trap: A health FSA is generally use-it-or-lose-it — unused funds are forfeited at year-end (a plan may allow a limited carryover or a short grace period, but not both).

Eligibility, Nondiscrimination, and the HSA Distinction

Section 125 is an employer-sponsored arrangement; only employees (and in some designs their spouses through the employee's election) participate. Self-employed individuals, partners, and more-than-2% S-corporation shareholders generally cannot participate on a pre-tax basis. The plan must also pass nondiscrimination tests so it does not disproportionately favor highly compensated or key employees; failing the test makes their benefits taxable.

Do not confuse a Health FSA with a Health Savings Account (HSA). An FSA is use-it-or-lose-it and is not tied to a specific plan design. An HSA requires enrollment in a qualifying high-deductible health plan (HDHP), the funds roll over year to year, and the account is owned by the individual — it travels with them after employment ends.

Trap: Exam items pair "use-it-or-lose-it" with HSA to bait you. Forfeiture is the FSA feature; rollover and portability belong to the HSA.

Worked Numeric: Pre-Tax Savings

Pre-tax elections reduce the wages on which tax is calculated. Suppose an employee earns $4,000/month and elects $400/month of health premium through a Section 125 POP, with a combined income + FICA tax rate of 30%.

Without Section 125:
  Taxes on full $4,000 = $1,200; then pay $400 premium with after-tax dollars
  Net pay = $4,000 − $1,200 − $400 = $2,400

With Section 125 (pre-tax):
  Taxable wages = $4,000 − $400 = $3,600
  Taxes = $3,600 × 30% = $1,080
  Net pay = $3,600 − $1,080 = $2,520

The pre-tax election saves $120/month — the 30% tax that would have applied to the $400 premium. Over a year that is $1,440 in tax savings, with no change in the benefit received.

Self-Funding, Stop-Loss, and ERISA

Instead of paying premiums to an insurer, a self-funded (self-insured) plan has the employer pay claims directly, usually administered by a third-party administrator (TPA). The employer assumes the claims risk but buys stop-loss insurance to cap catastrophic exposure.

Two Kinds of Stop-Loss

ERISA Preemption — the Key Distinction

Exam tip: ERISA preemption means a self-funded single-employer plan escapes state benefit mandates — but a self-funded MEWA does not. ERISA still requires a Summary Plan Description (SPD), Form 5500 filing, and fiduciary duties.

Why Employers Self-Fund, and the Role of the TPA

Large employers self-fund to capture several advantages while controlling risk:

• Cash-flow timing — the employer holds reserves and pays claims as incurred rather than prepaying premium to an insurer.
• No insurer profit/risk margin — only actual claims plus administration are paid.
• Plan-design flexibility — benefits are customized without state mandate constraints (single-employer plans).
• Data transparency — the employer sees exactly where claims dollars go.

The third-party administrator (TPA) processes claims, manages the provider network, handles eligibility, and issues explanations of benefits, but the TPA does not assume risk — that stays with the employer up to the stop-loss attachment points. An administrative-services-only (ASO) arrangement is the common contract under which an insurer or TPA performs these functions for a fee.

Trap: Self-funding does not mean the employer keeps unlimited risk. Specific and aggregate stop-loss are what make self-funding viable for mid-size employers.

FSA Use-It-or-Lose-It and the Health FSA Limit

A health FSA inside a Section 125 plan is funded by pre-tax salary reductions but carries the use-it-or-lose-it rule: unspent funds are forfeited at year-end, subject to an optional $640-range carryover or a 2½-month grace period (an employer may offer one, not both). This contrasts sharply with an HSA, where the balance is owned by the employee and rolls over indefinitely.

Self-Funding, Stop-Loss, and Who Bears Risk

In a self-funded plan the employer pays claims from its own assets and buys stop-loss insurance to cap exposure: specific stop-loss limits the loss on any one claimant, while aggregate stop-loss caps the plan's total annual claims. Because ERISA preempts state insurance regulation for self-funded plans, they escape state mandated benefits and premium taxes — the principal reason large employers self-fund, with a TPA administering claims.