12.4 Section 125 / Cafeteria Plans and Self-Funding

Employers use two cost-management tools the exam tests: Section 125 cafeteria plans (a tax structure) and self-funding (a financing structure). They solve different problems but often appear together.

Section 125 Cafeteria Plans

Named for the Internal Revenue Code section, a cafeteria plan lets each employee choose among taxable cash and a menu of qualified (tax-favored) benefits, paying for chosen benefits with pretax salary reductions. Because the employee must be able to choose taxable cash, the plan is genuinely a 'choice' arrangement.

Exam trap: Benefits paid through a cafeteria plan use pretax dollars, which lowers federal income and FICA taxable wages. That tax break is the whole point of Section 125.

Flexible Spending Accounts (FSAs)

A health FSA is funded by pretax salary reductions and reimburses qualified medical expenses. The defining exam rule is the use-it-or-lose-it provision: unused balances are generally forfeited at year-end (subject to a limited grace period or small carryover the employer may adopt).

Worked Example: Pretax Savings

An employee earns 50,000 dollars and elects 2,000 dollars into an FSA. Taxable wages drop to 48,000 dollars. At a combined 22% income plus 7.65% FICA rate (about 29.65%), the 2,000 dollars saves roughly 0.2965 x 2,000 = 593 dollars in taxes compared to paying those medical costs with after-tax dollars. But if the employee only spends 1,500 dollars, the remaining 500 dollars is forfeited.

Exam tip: Do not confuse an FSA with an HSA. HSAs (paired with high-deductible plans) are owned by the employee, roll over, and are portable. FSAs are employer-tied and use-it-or-lose-it.

Self-Funding and Stop-Loss

Instead of buying a fully insured plan, a self-funded (self-insured) employer pays employee medical claims from its own funds, usually hiring a third-party administrator (TPA) to process them. To cap catastrophic exposure, the employer buys stop-loss insurance.

Self-funded plans are governed by ERISA and are generally exempt from state insurance mandates and premium taxes, a major reason large employers self-fund. The trade-off is that the employer bears claims volatility directly, which is why experience matters and stop-loss is essential.

Exam point: Specific stop-loss = per-person ceiling; aggregate stop-loss = whole-group ceiling. ERISA preemption frees self-funded plans from many state mandates that fully insured plans must follow.

Eligible Cafeteria-Plan Benefits and Limits

Not every benefit can be offered pretax through Section 125. Qualified benefits generally include accident and health coverage, group-term life up to 50,000 dollars, disability, dependent-care assistance, and HSA contributions. Excluded items the exam likes to flag include long-term care insurance, scholarships, and most fringe benefits.

Elections are generally irrevocable for the plan year unless the employee has a qualifying status change (marriage, birth, divorce, or loss of other coverage). That irrevocability is what makes the FSA use-it-or-lose-it rule sting.

Why Employers Self-Fund and the Risk Trade-Off

Large employers self-fund to capture cash flow, avoid state premium taxes and many mandates, and benefit directly when claims run low. The cost is volatility: a few catastrophic claims can swamp a self-funded budget, which is exactly why specific and aggregate stop-loss exist. A common design pairs a 50,000 dollar specific attachment point with an aggregate attachment near 125% of expected claims.

Worked Example: Aggregate Stop-Loss

Expected annual claims are 2,000,000 dollars and the aggregate attachment is 125%, or 2,500,000 dollars. If actual claims reach 2,700,000 dollars, aggregate stop-loss reimburses the 200,000 dollars above the 2,500,000 threshold; the employer funds claims up to the attachment point itself.

Exam tip: Fully insured = insurer bears risk and state insurance law applies. Self-funded = employer bears risk, buys stop-loss, and ERISA preemption applies. Section 125 is a tax wrapper that can sit on top of either funding choice.

Cafeteria-Plan Components and Stop-Loss Layers

A Section 125 cafeteria plan lets employees choose among qualified benefits using pre-tax salary, lowering both income and FICA taxes. Its components are tested individually: a premium-only plan (POP) simply lets employees pay their share of group premiums pre-tax; a flexible spending arrangement (FSA) sets aside pre-tax salary for medical or dependent-care expenses but is subject to use-it-or-lose-it with only a limited carryover or grace period; and a full cafeteria plan offers a menu of taxable and nontaxable benefits from which employees build a package.

The hard rule the exam stresses is that election changes are locked for the plan year unless a qualifying status change occurs, and cash or deferred compensation generally cannot be offered (except a 401(k) feature), or the plan loses its tax status.

Self-funding adds two protective stop-loss layers that questions often quantify. Specific (individual) stop-loss caps the employer's exposure on any one covered person; if the specific attachment is $50,000 and one member incurs $80,000 of claims, the reinsurer reimburses the $30,000 above the threshold while the employer funds the first $50,000. Aggregate stop-loss caps the employer's total exposure across the whole group; with expected claims of $2,000,000 and a 125% aggregate attachment of $2,500,000, actual claims of $2,700,000 trigger $200,000 of aggregate reimbursement.

Tie funding to regulation: a fully insured plan places risk on the insurer and is governed by state insurance law, including premium taxes and mandated benefits, while a self-funded plan keeps risk with the employer, buys stop-loss to limit it, and enjoys ERISA preemption from most state mandates. Section 125 is a tax wrapper that can sit on top of either funding choice, which is why exam items separate the funding question from the tax-treatment question.