12.4 Section 125 / Cafeteria Plans and Self-Funding
Key Takeaways
- Section 125 cafeteria plans let employees pay benefit premiums with pre-tax dollars, lowering taxable income.
- Health FSAs are use-it-or-lose-it with a 2026 contribution cap; limited carryover or a grace period may apply.
- HSAs require an HDHP, are owned by the employee, and roll over indefinitely; HRAs are employer-funded and employer-owned.
- Self-funded plans have the employer pay claims directly, are governed by ERISA, and often use stop-loss insurance.
Employers fund and structure benefits in ways that change their tax treatment. The exam tests Section 125 cafeteria plans (pre-tax choice plans) and self-funding (the employer bearing claim risk).
Section 125 Cafeteria Plans
Named for the Internal Revenue Code section that authorizes them, cafeteria plans let employees choose among qualified pre-tax benefits and cash. Because elected benefits are paid with pre-tax dollars, they reduce the employee's taxable income.
Common Cafeteria Plan Components
| Component | What It Does | Funding |
|---|---|---|
| Premium-Only Plan (POP) | Pays insurance premiums pre-tax | Employee salary reduction |
| Health FSA | Reimburses out-of-pocket medical costs | Employee (pre-tax) |
| Dependent-Care FSA | Reimburses child/dependent care | Employee (pre-tax) |
| Full "cafeteria" menu | Lets employees pick from a benefit menu plus cash | Mix |
A core rule: cafeteria plans must offer at least one taxable option (cash) and one qualified benefit, and elections are generally irrevocable for the plan year unless the employee has a qualifying life event (marriage, birth, divorce, loss of other coverage).
FSA, HSA, and HRA Compared
These pre-tax accounts look similar but differ on ownership, rollover, and eligibility — a frequent exam distinction.
| Feature | Health FSA | HSA | HRA |
|---|---|---|---|
| Who funds | Employee (pre-tax) | Employee and/or employer | Employer only |
| Who owns | Employer plan | Employee (portable) | Employer |
| Requires HDHP? | No | Yes | No |
| Rollover | Use-it-or-lose-it (limited carryover/grace period) | Unlimited, rolls over and grows | Employer decides |
- The Health FSA is use-it-or-lose-it: unspent funds are forfeited at year-end, though plans may allow a limited carryover or a grace period (not both). The 2026 salary-reduction cap is set by the IRS (about $3,300, indexed).
- The HSA requires enrollment in a High-Deductible Health Plan (HDHP), is owned by the employee, is portable, and rolls over indefinitely.
- The HRA is funded only by the employer, owned by the employer, and reimburses qualified expenses on employer terms.
Worked Tax-Savings Example
Suppose an employee earns $60,000 and elects $3,000 of pre-tax FSA contributions through a Section 125 plan. If the employee's combined marginal tax rate (federal + FICA + state) is 30%:
- Taxable income drops from $60,000 to $57,000.
- Tax saved = $3,000 x 0.30 = $900.
The $3,000 of medical or dependent-care spending costs the employee only $2,100 in after-tax terms. This pre-tax leverage is the main selling point of cafeteria plans, but the FSA's forfeiture risk means employees should not over-elect.
Which account requires the employee to be enrolled in a High-Deductible Health Plan and rolls over unused funds indefinitely?
Self-Funded (Self-Insured) Plans
Instead of buying a fully insured group policy, a large employer may self-fund: it pays employee claims directly from its own assets rather than transferring the risk to an insurer. The employer often hires a third-party administrator (TPA) or an administrative-services-only (ASO) arrangement to process claims.
Key features tested:
- ERISA governs self-funded plans, which preempts most state insurance mandates and is why large multistate employers favor self-funding.
- The employer keeps the cash flow and reserves it would otherwise pay an insurer, but it bears the claim risk.
- To cap that risk, employers buy stop-loss insurance:
- Specific (individual) stop-loss caps the employer's liability per covered person.
- Aggregate stop-loss caps total claims for the whole group in a year.
Worked Stop-Loss Example
If an employer sets a specific stop-loss attachment point of $50,000 and one employee incurs $180,000 in claims, the employer pays the first $50,000 and the stop-loss carrier reimburses the remaining $130,000.
An employer self-funds its health plan with specific stop-loss at a $40,000 attachment point. An employee incurs $95,000 in claims. How much does the stop-loss carrier reimburse?
Fully Insured vs. Self-Funded
The choice between buying a group policy and self-funding turns on who carries the risk and which law governs.
| Feature | Fully Insured | Self-Funded |
|---|---|---|
| Who pays claims | The insurer | The employer (often via a TPA) |
| Who bears risk | The insurer | The employer (capped by stop-loss) |
| Governing law | State insurance law + ERISA | ERISA (preempts most state mandates) |
| State premium taxes | Apply | Generally do not apply |
| Cash-flow control | Insurer holds reserves | Employer holds reserves |
ERISA (the Employee Retirement Income Security Act) sets minimum standards for employer-sponsored welfare and pension plans: a written plan document, a Summary Plan Description (SPD) for participants, fiduciary duties, and a claims-appeal process. Because ERISA preempts most state insurance mandates for self-funded plans, large multistate employers self-fund to apply one uniform plan design across states and to avoid state premium taxes.
Dependent-Care FSA and Election Rules
The Dependent-Care FSA is a separate Section 125 account that reimburses work-related child-care and dependent-care costs with pre-tax dollars. Its annual limit is set by tax law (commonly $5,000 for a married couple filing jointly, $2,500 if married filing separately) and is not the same pool as the health FSA. It is also use-it-or-lose-it.
Why Elections Are Locked
Cafeteria-plan elections are generally irrevocable for the plan year to prevent employees from gaming the tax benefit. An employee cannot raise an FSA election mid-year just because a large medical bill appeared. Changes are allowed only after a qualifying life event - marriage, divorce, birth or adoption, a change in employment status, or loss of other coverage - and the election change must be consistent with that event.
This irrevocability, paired with FSA forfeiture, is why agents counsel employees to estimate annual expenses conservatively before electing. HSAs, by contrast, can be adjusted any time and never forfeit, which is a frequent exam contrast point.