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 (cash) and one qualified benefit.
- Health FSAs follow use-it-or-lose-it; an employer may offer either a 2.5-month grace period or a limited carryover, never both.
- Cafeteria-plan tax savings equal the avoided tax on pre-tax dollars, not a refund of the full election amount.
- Self-funded employers pay claims directly, use a TPA, and buy specific and aggregate stop-loss; ERISA preempts most state insurance regulation.
- Employer-paid group term life is tax-free only up to $50,000; coverage above that creates imputed income under IRS Table I.
Employers fund and structure health benefits in ways that carry distinct tax and risk consequences. This section covers Section 125 cafeteria plans, flexible spending accounts, and self-funded arrangements, all favorites on the licensing exam because of their tax mechanics.
Section 125 Cafeteria Plans
A cafeteria plan, authorized by Internal Revenue Code Section 125, lets employees choose among a menu of qualified benefits and cash, paying for chosen benefits with pre-tax dollars. Because contributions come out before federal income and FICA taxes, the employee's taxable wage base shrinks.
| Benefit available in a cafeteria plan | Typical form |
|---|---|
| Health insurance premiums | Premium-only plan (POP) |
| Medical expenses | Health flexible spending account (FSA) |
| Dependent/child care | Dependent care FSA |
| Group term life (first $50,000) | Tax-favored death benefit |
A cafeteria plan must offer at least one taxable benefit (cash) and one qualified benefit. Benefits that cannot be in a Section 125 plan include long-term care insurance and most scholarships, a common exam distractor.
Flexible Spending Accounts and the Use-It-or-Lose-It Rule
A health FSA lets an employee set aside pre-tax salary to reimburse out-of-pocket medical costs. The catch is the use-it-or-lose-it rule: unused funds at year-end are generally forfeited. The IRS permits employers to offer one relief option, but not both:
- A grace period of up to 2.5 months into the next year to incur expenses, or
- A carryover of a limited dollar amount (indexed annually) into the next plan year.
The health FSA has an annual salary-reduction limit set by the IRS and indexed for inflation. Dependent care FSAs carry a separate statutory cap (commonly $5,000 for a married couple filing jointly).
Worked Example: Cafeteria Plan Tax Savings
Lena earns $60,000 and elects $3,000 of pre-tax benefits through a Section 125 plan. Her combined income and FICA rate is 30%.
- Taxable income drops to $60,000 - $3,000 = $57,000.
- Tax saved = $3,000 x 30% = $900.
- Net cost of $3,000 in benefits = $3,000 - $900 = $2,100.
The trap: the employee does not get the $3,000 back; the savings is only the tax avoided on those dollars.
Self-Funded (Self-Insured) Plans
In a self-funded plan the employer pays claims directly from its own assets instead of paying premiums to an insurer. The employer bears the risk and often hires a third-party administrator (TPA) to process claims. To cap exposure, employers buy stop-loss insurance.
| Stop-loss type | Protects against |
|---|---|
| Specific (individual) stop-loss | One person's claims exceeding a set attachment point |
| Aggregate stop-loss | Total plan claims exceeding an expected threshold |
ERISA Preemption
Self-funded plans are governed by the federal ERISA statute and are largely exempt from state insurance regulation and state-mandated benefits. This preemption is a key reason large employers self-fund: they escape varying state mandates and premium taxes. A fully insured plan, by contrast, is subject to state insurance law.
Group Term Life Tax Trap
Employer-paid group term life is tax-free to the employee only up to $50,000 of coverage. The cost of coverage above $50,000 is imputed income taxed to the employee using the IRS Table I rates, a detail frequently paired with cafeteria-plan questions.
Comparing Funding Approaches
The choice between fully insured and self-funded turns on size, cash flow, and risk appetite.
| Feature | Fully insured | Self-funded |
|---|---|---|
| Who pays claims | Insurer (employer pays premium) | Employer (from its own assets) |
| Regulation | State insurance law applies | ERISA preempts most state law |
| Risk to employer | Fixed premium, no claims risk | Bears claims risk, capped by stop-loss |
| Best fit | Smaller employers | Large employers with stable cash flow |
Smaller employers favor fully insured plans for the budget certainty of a fixed premium. Larger employers self-fund to capture cash-flow advantages, avoid state premium taxes, and escape state benefit mandates, accepting claims volatility that stop-loss insurance contains.
Why the Tax Treatment Matters
The pre-tax nature of Section 125 contributions is the entire reason these plans exist: every dollar routed through the plan dodges income and payroll tax, lowering the true cost of benefits for the employee and the employer's matching FICA. Exam questions test whether you can identify which benefits qualify for that pre-tax treatment and which (long-term care, scholarships) do not.
Self-Funding, Stop-Loss, and ASO
Larger employers often self-fund group health, paying claims directly from corporate assets rather than buying a fully insured policy. They retain the risk (and the cash-flow and ERISA advantages) but buy stop-loss insurance to cap exposure:
- Specific (individual) stop-loss — caps the employer's liability for any one member's claims (e.g., $50,000).
- Aggregate stop-loss — caps total plan claims for the year (e.g., 125% of expected).
An Administrative Services Only (ASO) contract lets the employer hire an insurer or third-party administrator to process claims and administer the plan without assuming the insurance risk.
Trap: Under self-funding the employer, not an insurer, bears claims risk; stop-loss is the transfer device that limits catastrophic loss, and ASO buys only administration, not risk-bearing.
Under IRS rules, an employer offering a health FSA may provide which ONE relief from the use-it-or-lose-it rule?
A large employer pays its medical claims directly from company assets and buys coverage to limit losses from any single catastrophic claim. The arrangement and the coverage are best described as: