12.4 Section 125 / Cafeteria Plans and Self-Funding

Employers fund and structure health benefits in ways that carry distinct tax and risk consequences. The exam concentrates on three things: Section 125 cafeteria plans (how employees pay with pre-tax dollars), the taxation of group health benefits, and the difference between fully insured and self-funded plans.

Section 125 Cafeteria Plans

Named for the Internal Revenue Code section, a cafeteria plan lets employees choose between taxable cash and qualified pre-tax benefits. Employees fund elected benefits with pre-tax salary reductions, lowering taxable income.

Common Cafeteria-Plan Components

• Flexible Spending Account (FSA) — pre-tax dollars for medical or dependent-care expenses. Subject to a use-it-or-lose-it rule, softened by an optional grace period or a limited carryover.
• Health Savings Account (HSA) — paired with a qualified High-Deductible Health Plan (HDHP); contributions are tax-advantaged and balances roll over indefinitely and are portable.
• Premium-only plan (POP) — lets employees pay their share of group premiums pre-tax.

Key trap: FSA = use-it-or-lose-it and not portable; HSA = rolls over and is owned by the employee. Confusing the two is a classic missed question.

Taxation of Group Health Benefits

This is heavily tested. Walk through who deducts and who is taxed.

Worked example: An employer pays 100% of a group disability income premium. Because the employer deducted the premium and the employee was not taxed on it, the monthly disability benefit is taxable income to the employee. Flip it — if the employee paid the premium with after-tax dollars, the benefit would be received income-tax-free. The rule: whoever was taxed on the premium controls whether the benefit is taxed.

Group medical benefits, by contrast, are generally tax-free to the employee regardless of who paid, because the premiums were not counted as the employee's income.

Fully Insured vs. Self-Funded Plans

In a fully insured plan the employer pays premiums and the insurer bears the claims risk. In a self-funded (self-insured) plan the employer pays claims directly from its own funds, often hiring a Third-Party Administrator (TPA) and buying stop-loss insurance to cap catastrophic exposure.

Stop-loss comes in two forms: specific stop-loss caps the employer's cost per individual claimant, and aggregate stop-loss caps total annual claims for the whole group. Because self-funded plans fall under ERISA, they are largely exempt from state mandates, which is why large national employers favor them. ERISA also requires a Summary Plan Description (SPD) be furnished to participants.

Cafeteria plans and flexible spending accounts

A Section 125 (cafeteria) plan lets employees choose among qualified benefits and cash on a pre-tax basis, lowering taxable income. The most common component is a Flexible Spending Account (FSA), funded by pre-tax salary reductions to pay unreimbursed medical or dependent-care costs. The key FSA trap is the use-it-or-lose-it rule: unspent balances are generally forfeited at year-end (subject to a limited carryover or grace period the employer may adopt), which sharply distinguishes an FSA from a roll-over-everything HSA.

A cafeteria plan must offer at least one taxable option (cash) and one qualified benefit, and elections are generally irrevocable for the plan year absent a qualifying life event. The exam contrasts the employer-friendly tax leverage of Section 125 with the forfeiture risk that pushes careful employees to estimate FSA contributions conservatively.

Fully insured versus self-funded plans

Employers finance group health two ways. Under a fully insured plan, the employer pays premiums and the insurer bears the claims risk — predictable cost, but the employer is subject to state insurance regulation and premium taxes. Under a self-funded (self-insured) plan, the employer pays claims directly out of its own funds, bears the claims risk, and is largely exempt from state mandates under ERISA preemption — attractive to large employers but risky if claims spike.

Self-funded employers commonly buy stop-loss (excess) insurance to cap exposure: specific stop-loss limits the cost of any one claimant, while aggregate stop-loss limits total annual claims. Worked tax point: when an employer pays the entire premium for a group disability plan and deducts it, the benefits become taxable to the employee — the same premium-paid rule that governs all employer-funded health benefits.

Premium-only plans and stop-loss layers

The simplest Section 125 arrangement is a premium-only plan (POP), which merely lets employees pay their share of group premiums with pre-tax dollars, reducing both income and payroll taxes. A full cafeteria plan adds menu choices and FSAs. On the financing side, a self-funded employer manages cash-flow risk with two stop-loss layers: specific (individual) stop-loss reimburses claims on any one person above a per-person attachment point, while aggregate stop-loss reimburses total plan claims above an annual threshold.

The exam expects you to connect the tax leverage of Section 125 to the risk-transfer logic of stop-loss: cafeteria plans cut employees' taxes, and stop-loss insurance protects a self-funded employer from the catastrophic claims that would otherwise make self-funding too risky.