12.4 Section 125 / Cafeteria Plans and Self-Funding
Key Takeaways
- A Section 125 cafeteria plan lets employees buy qualified benefits with pre-tax dollars and must offer at least one taxable and one nontaxable option.
- FSAs follow use-it-or-lose-it; HSAs require a qualifying HDHP, roll over, are portable, and give a triple tax advantage.
- HRAs are employer-funded, and the employer retains any unused balance.
- Self-funded plans pay claims from company assets, are governed federally by ERISA, and avoid many state mandates and premium taxes.
- Stop-loss protects the employer: specific caps a single claimant; aggregate caps total annual claims.
Section 125 / Cafeteria Plans and Self-Funding
Employers use tax-advantaged structures to deliver benefits efficiently. The cafeteria plan, authorized under Section 125 of the Internal Revenue Code, lets employees choose among a menu of qualified benefits using pre-tax dollars. The plan must offer at least one taxable option (usually cash) and at least one qualified nontaxable benefit (such as health coverage). Because contributions are pre-tax, employees lower their taxable income and the employer reduces payroll-tax exposure.
The phrase "cafeteria" captures the idea: employees select benefits the way they would pick items from a cafeteria line, tailoring the package to their needs within employer-set limits.
FSAs, HSAs, and the Use-It-or-Lose-It Rule
Common components of Section 125 and consumer-driven plans:
| Account | Funded By | Key Feature |
|---|---|---|
| Flexible Spending Account (FSA) | Employee pre-tax salary reduction | Use-it-or-lose-it; 2026 contribution limit $3,300 |
| Health Savings Account (HSA) | Employee and/or employer pre-tax | Must pair with a qualifying HDHP; funds roll over and are portable |
| Health Reimbursement Arrangement (HRA) | Employer only | Reimburses qualified expenses; employer owns unused funds |
FSA trap: the use-it-or-lose-it rule means unspent FSA funds are generally forfeited at year-end, though a plan may allow a short grace period or a limited carryover. An HSA, by contrast, is owned by the employee, rolls over indefinitely, and is portable when changing jobs — and it must be paired with a High-Deductible Health Plan (HDHP).
HSA Worked Example
Assume an employee enrolls in a qualifying HDHP and contributes the self-only maximum. A simplified illustration:
| Item | Amount |
|---|---|
| Pre-tax HSA contribution | $4,150 |
| Marginal tax rate | 24% |
| Tax saved on contribution | $4,150 × 0.24 = $996 |
| Qualified medical withdrawal | Tax-free |
| Unused balance at year-end | Rolls over (not forfeited) |
The HSA delivers a triple tax advantage: contributions are pre-tax, growth is tax-deferred, and qualified withdrawals are tax-free. Compare this to the FSA, where the same unused balance would generally be forfeited under use-it-or-lose-it.
Self-Funding (Self-Insurance) and Stop-Loss
Instead of buying a fully insured plan, large employers may self-fund — paying employee claims directly out of company assets. Self-funding avoids state premium taxes, lets the employer hold reserves, and is generally regulated federally under ERISA rather than by state insurance law.
To cap the financial risk, self-funded employers buy stop-loss insurance:
- Specific (individual) stop-loss: caps the employer's liability on any one claimant.
- Aggregate stop-loss: caps the employer's total liability across all claims for the year.
Trap: Self-funded plans are typically governed by ERISA (federal), so many state mandates do not apply. Stop-loss does not pay employees — it reimburses the employer once claims exceed the attachment point.
Stop-Loss Attachment Point Worked Example
Stop-loss pays only after claims pass an attachment point (the employer's retained deductible). Specific example: a plan carries a $75,000 specific attachment point per person. One employee incurs $210,000 in claims during the year. The employer self-funds the first $75,000; the specific stop-loss carrier reimburses the excess of 210,000 − 75,000 = $135,000.
Aggregate example: the carrier sets an aggregate attachment at 125% of expected claims. Expected claims are $2,000,000, so the aggregate point is 2,000,000 × 1.25 = $2,500,000. If total group claims reach $2,650,000, aggregate stop-loss reimburses 2,650,000 − 2,500,000 = $150,000.
Who regulates these vehicles matters for the exam. Fully insured group plans are state-regulated and subject to state mandates and premium tax. Self-funded ERISA plans are largely exempt from those state mandates, though the stop-loss policy itself is a state-regulated insurance product. This federal/state split is a recurring test point: the benefit plan is federal, the stop-loss contract is state insurance.
An employee contributes to an FSA but has $400 left unspent at year-end with no grace period or carryover. What generally happens to that money?
A self-funded employer wants to limit its liability for any single high-cost claimant. Which coverage applies, and who is reimbursed?
Account Comparison Grid and a Stop-Loss Attachment Worked Example
Section 125 plans and self-funding are tested through the differences among the consumer-driven accounts and through the stop-loss math that caps an employer's self-funded risk. A side-by-side grid settles the account questions.
| Account | Owned by | Rollover | Must pair with HDHP |
|---|---|---|---|
| FSA | Employee (employer plan) | No (use-it-or-lose-it) | No |
| HSA | Employee | Yes, indefinitely; portable | Yes |
| HRA | Employer | Employer's discretion | No |
The defining traps: the FSA forfeits unspent funds at year-end (subject only to a limited grace period or carryover), while the HSA rolls over forever and follows the employee to a new job — and the HSA is valid only when paired with a qualifying High-Deductible Health Plan. A Section 125 cafeteria plan is the wrapper that lets employees fund these with pre-tax dollars, and it must always offer at least one taxable option (cash) plus at least one qualified benefit.
Self-funding worked example with stop-loss: a self-funded employer carries a $75,000 specific attachment point. One employee incurs $260,000 in claims; the employer pays the first $75,000 and the specific stop-loss reimburses $260,000 − $75,000 = $185,000. Separately, the aggregate attachment is set at 125% of $3,000,000 expected claims = $3,750,000; if total group claims reach $3,900,000, aggregate stop-loss reimburses $3,900,000 − $3,750,000 = $150,000.
The regulatory split is the recurring exam point: the self-funded benefit plan is governed by ERISA (federal) and escapes most state mandates, but the stop-loss policy itself is a state-regulated insurance contract that reimburses the employer, never the employee.