12.4 Section 125 / Cafeteria Plans and Self-Funding

Employers structure benefits to save taxes and control cost. Two exam-tested mechanisms are Section 125 cafeteria plans (how benefits are paid for pre-tax) and self-funding (how the employer bears the risk directly).

Section 125 Cafeteria Plans

A cafeteria plan, authorized by Internal Revenue Code Section 125, lets employees choose among qualified benefits and pay for them with pre-tax dollars. Lowering taxable income reduces both income and FICA taxes.

A plan must offer at least one taxable benefit (usually cash) and one qualified benefit. Deferred compensation (other than 401(k)) generally cannot be offered.

Flexible Spending Accounts (FSAs)

FSAs are funded by pre-tax salary reductions and reimburse qualified out-of-pocket costs.

• Use-it-or-lose-it: Unused funds are generally forfeited at year-end. Plans may offer either a carryover (a limited dollar amount rolling to the next year) or a grace period (extra months to spend), but not both.
• Uniform coverage rule: The full annual health-FSA election is available on day one, even though contributions come in over the year.

Worked example: An employee elects $2,000 to a health FSA. In January she incurs $1,800 in eligible costs. The plan must reimburse the full $1,800 immediately under the uniform coverage rule, even though she has only contributed about $167 so far. If she contributes the full $2,000 but spends only $1,700 by year-end, the remaining $300 is forfeited unless a carryover or grace period applies.

Self-Funding (Self-Insurance)

Instead of buying a fully insured policy, a large employer may self-fund: it pays claims directly from its own assets and often hires a third-party administrator (TPA) to process them.

Stop-Loss Insurance

To cap its risk, a self-funded employer buys stop-loss (excess) insurance:

Worked example: A self-funded plan has specific stop-loss with a $100,000 attachment point. One employee incurs $260,000 in claims. The plan pays the first $100,000; the stop-loss carrier reimburses the $160,000 above the attachment point.

Because self-funded ERISA plans are exempt from most state insurance regulation and premium taxes, large employers favor them for flexibility and cost savings.

ERISA and Plan Administration

Most private-employer group health and welfare plans are governed by the Employee Retirement Income Security Act (ERISA), a federal law administered by the Department of Labor. ERISA imposes fiduciary and disclosure duties rather than benefit mandates.

ERISA's preemption clause is why self-funded plans escape state insurance mandates: a self-funded plan is treated as an employee benefit plan, not as insurance, so states cannot regulate it as insurance or levy premium tax on it. Fully insured plans, by contrast, are reached by the states through the insurer that issues the policy.

Choosing Self-Funding vs. Fully Insured

The decision turns on size, cash flow tolerance, and risk appetite.

• Large, stable employers prefer self-funding to capture savings on premium taxes and insurer profit/risk charges and to design custom benefits.
• Small employers usually stay fully insured because a few large claims could overwhelm them; stop-loss makes self-funding feasible only above a certain size.
• Level-funded arrangements blend the two: the employer pays a steady monthly amount that funds claims, administration, and stop-loss, with a possible refund if claims run low—giving smaller groups self-funded economics with predictable cash flow.

Aggregate stop-loss example: A plan's expected annual claims are $1,000,000 and its aggregate attachment point is 125%, or $1,250,000. If actual claims reach $1,400,000, the employer funds up to $1,250,000 and the stop-loss carrier reimburses the $150,000 above the aggregate attachment point.

A frequent exam trap distinguishes the two stop-loss layers: specific protects against one catastrophic individual claim, while aggregate protects against many ordinary claims piling up beyond the expected total. A well-designed self-funded plan usually buys both so that neither a single large case nor a bad claims year can threaten the employer's solvency.

FSA Use-It-or-Lose-It and Stop-Loss in Self-Funding

Two numeric rules recur. A health Flexible Spending Account (FSA) funded through a Section 125 plan is subject to a use-it-or-lose-it rule — unused balances are generally forfeited at year-end, though employers may offer a limited carryover or a short grace period. Contributions are pre-tax, lowering both income and payroll tax.

In a self-funded (self-insured) plan the employer pays claims directly and buys stop-loss insurance to cap risk: specific stop-loss limits the employer's liability per individual claimant, while aggregate stop-loss caps total claims for the group. Worked example: with a $50,000 specific attachment point, the employer pays the first $50,000 of any one member's claims and the stop-loss carrier pays above that. ERISA, not state mandates, primarily governs self-funded plans.