12.4 Section 125 / Cafeteria Plans and Self-Funding

Section 125 Cafeteria Plans

A Section 125 plan (named for the Internal Revenue Code section) lets employees choose between taxable cash and qualified pre-tax benefits — like picking from a cafeteria menu. The headline advantage is that elected benefits are paid with pre-tax dollars, lowering the employee's taxable wages and payroll taxes.

To qualify, the plan must offer at least one taxable option (cash) and at least one qualified non-taxable benefit. Elections are generally irrevocable for the plan year unless a qualifying life event (marriage, birth, divorce, change in employment) permits a mid-year change.

Common Section 125 Components

Health FSA limits and the use-it-or-lose-it rule: funds left at year-end are generally forfeited. Plans may offer either a limited carryover (an inflation-indexed amount, e.g., around $640) or a 2½-month grace period, but not both.

HSAs vs. FSAs

A Health Savings Account (HSA) is distinct from an FSA and requires enrollment in a High-Deductible Health Plan (HDHP).

HSA contributions are pre-tax, growth is tax-deferred, and qualified withdrawals are tax-free — the "triple tax advantage." The HSA stays with the employee after leaving the job; an FSA typically does not.

Self-Funded (Self-Insured) Plans

Instead of paying premiums to an insurer, a self-funded employer pays employee claims directly out of its own funds, usually using a Third-Party Administrator (TPA) to process claims. Large employers favor this for cash-flow control, customization, and avoidance of insurer profit margins.

The defining legal feature is ERISA preemption: self-funded plans are largely exempt from state insurance laws and mandates. Fully insured plans, by contrast, remain subject to state regulation. A noted exception — self-funded MEWAs (multiple-employer arrangements) remain subject to state oversight.

Stop-Loss Insurance

Self-funded employers buy stop-loss coverage to cap their catastrophic risk:

• Specific (individual) stop-loss — caps claims on one person (e.g., the employer pays the first $100,000 per individual; the carrier pays above that).
• Aggregate stop-loss — caps total plan claims (e.g., the carrier pays once claims exceed 125% of expected).

Stop-loss lets the employer self-fund routine claims while transferring tail risk, capturing most self-funding savings without unlimited exposure.

ERISA Disclosure Duties

Self-funded and most private employer plans are governed by ERISA, which imposes administrative duties rather than mandating benefits:

The SPD is not the same as the certificate: the SPD is an ERISA disclosure explaining the plan in understandable terms, while a certificate evidences insured coverage. Both can exist for the same plan.

FSA Worked Example and the MEC Contrast

Health FSA forfeiture: an employee elects $2,000 into a health FSA but incurs only $1,650 of qualified expenses. Under use-it-or-lose-it, the $350 balance is forfeited unless the plan offers a carryover or grace period. If the plan has a $640 carryover, the full $350 rolls into next year; if it instead has a 2½-month grace period, the employee can spend the $350 by mid-March.

Do not confuse a Section 125 plan with life-insurance MEC testing. A Modified Endowment Contract results when life-policy premiums exceed the 7-pay test limit; that is a life-insurance taxation concept, unrelated to cafeteria-plan elections — a deliberate cross-topic distractor.

Funding Models Side by Side

Understanding the funding spectrum clarifies who bears risk and which laws apply:

Level-funded plans blend the two: the employer pays a steady monthly amount that covers expected claims plus stop-loss, and the carrier refunds surplus or absorbs overage at year-end. On the exam, the dividing line to remember is risk-bearing — if the employer pays claims and buys stop-loss, it is self-funded and ERISA-preempted from state mandates.

Why Employers Self-Fund (and the Trade-Offs)

Large employers self-fund to capture savings and control. The advantages are concrete:

• Cash flow — the employer holds reserves instead of prepaying premiums; money earns interest until claims are paid.
• No premium tax or insurer profit load baked into the cost.
• Plan-design freedom — ERISA preemption lets a multi-state employer run one uniform plan instead of complying with 50 sets of state mandates.
• Data transparency — direct access to claims data for cost management.

The trade-off is risk: a bad claims year can spike costs, which is precisely why specific and aggregate stop-loss exist. Smaller employers usually cannot absorb that volatility, so they stay fully insured or choose level-funding.