12.4 Section 125 / Cafeteria Plans and Self-Funding

Employers structure how benefits are chosen, paid for, and funded. Two heavily tested vehicles are the Section 125 cafeteria plan (which lets employees pay for benefits with pre-tax dollars and choose among options) and self-funding (where the employer pays claims directly instead of buying insurance). Both change the tax and risk picture, so the exam frames them around who saves taxes and who bears risk.

Section 125 Cafeteria Plans

Named for Internal Revenue Code Section 125, a cafeteria plan lets employees choose between taxable cash and a menu of qualified, tax-favored benefits. Money directed into qualified benefits is deducted before income and FICA taxes, lowering the employee's taxable income. At least one taxable option (usually cash) must be offered, or the plan loses its Section 125 status.

Components of a Cafeteria Plan

The FSA Use-It-or-Lose-It Rule

An FSA is funded by an annual salary-reduction election the employee sets before the year begins. Historically, unused funds were forfeited at year-end, the use-it-or-lose-it rule. The IRS now permits an employer to choose one of two relief options: a carryover of a limited amount into the next year, or a grace period of up to 2.5 months to incur expenses. An employer may not offer both.

Exam tip: Cafeteria-plan benefits are pre-tax, which lowers taxable income. A common trap claims the employee is taxed on amounts put into the plan; the whole point is the opposite. Also remember an FSA election is generally irrevocable for the plan year absent a qualifying life event.

Pre-Tax Savings, Worked Example

An employee earns $60,000 and elects $3,000 of pre-tax benefits through a cafeteria plan. Assume a combined 22% income-tax bracket plus 7.65% FICA = 29.65% marginal rate.

• Taxable income drops from $60,000 to $57,000.
• Tax saved: $3,000 x 29.65% = $889.50 in the employee's pocket versus paying for the same benefit with after-tax dollars.

Self-Funded (Self-Insured) Plans

In a self-funded plan, the employer sets aside money and pays employee claims directly rather than transferring the risk to an insurer. The employer bears the claims risk and reaps the savings if claims are low.

Controlling the Risk: Stop-Loss Insurance

Because one catastrophic claim could be ruinous, self-funded employers buy stop-loss (excess) insurance.

• Specific (individual) stop-loss caps the employer's liability for any one person's claims (for example, the employer pays the first $50,000 per person; the stop-loss carrier pays above that).
• Aggregate stop-loss caps the employer's total claims for the year (for example, the carrier pays once total claims exceed 125% of expected).

Administrative Services Only (ASO)

A self-funded employer often hires a third-party administrator under an administrative-services-only (ASO) arrangement to process claims, handle networks, and manage paperwork, without transferring the underlying claims risk. The employer still owns the risk; the administrator just runs the plan.

Exam trap: Self-funded plans are generally exempt from state insurance laws under ERISA preemption, which is why large multistate employers favor them. A question may ask which plan type escapes state-mandated benefits; the answer is the self-funded plan.

Premium-Only Plans, FSAs, and the Use-It-or-Lose-It Rule

The simplest cafeteria plan is a Premium-Only Plan (POP), which lets employees pay their share of group-insurance premiums with pre-tax dollars, lowering taxable wages and payroll tax for both sides. A fuller Flexible Spending Arrangement (FSA) adds a health-care and/or dependent-care account funded by pre-tax salary reduction. The classic exam point is the use-it-or-lose-it rule: unspent FSA balances are generally forfeited at year-end, though the IRS permits an optional grace period of up to two and a half months or a limited carryover, but never both.

Self-Funding and Stop-Loss Mechanics

A self-funded (self-insured) employer pays employee health claims directly rather than buying insurance, capturing cash flow and avoiding state premium taxes and most state mandates because ERISA preempts state regulation of self-funded plans. To cap risk the employer buys stop-loss coverage:

Worked Stop-Loss Example

An employer self-funds with a $75,000 specific attachment point and a 125% aggregate attachment. One employee incurs $200,000 in claims; the stop-loss reimburses the $125,000 above the $75,000 specific point. Separately, if total plan claims for the year exceed 125% of expected (say expected was $1,000,000, so the threshold is $1,250,000), aggregate stop-loss reimburses claims above $1,250,000. The two layers together let a mid-size employer self-fund without betting the company on a single catastrophic case.

Additional Exam Traps

• A cafeteria plan must offer a choice between cash and qualified benefits; an all-benefits-no-cash design is not a 125 plan.
• FSA forfeitures follow use-it-or-lose-it, softened only by either a grace period or a carryover.
• Self-funded plans are governed by ERISA, escaping most state mandates and premium tax.