12.4 Section 125 / Cafeteria Plans and Self-Funding
Key Takeaways
- A Section 125 cafeteria plan lets employees pay for qualified benefits with pre-tax dollars, lowering taxable income and payroll taxes.
- A health FSA is use-it-or-lose-it; for 2026 it has a salary-reduction limit (about $3,300, indexed) and allows a limited carryover or a 2.5-month grace period, but not both.
- Premium-only plans (POP), full cafeteria plans, and FSAs are the main Section 125 structures.
- Self-funded plans have the employer pay claims directly, are governed by ERISA, and use stop-loss insurance to cap catastrophic risk.
- Specific stop-loss caps the cost per individual; aggregate stop-loss caps the plan's total claims for the year.
Two employer-plan structures round out the group chapter: Section 125 cafeteria plans (how employees pay) and self-funding (how employers carry the risk).
Section 125 Cafeteria Plans
Named for the Internal Revenue Code section, a cafeteria plan lets employees choose among qualified benefits and pay for them with pre-tax dollars. Reducing taxable wages lowers both income tax and FICA payroll tax for the employee, and FICA for the employer.
Common Section 125 Structures
| Structure | What It Does |
|---|---|
| Premium-only plan (POP) | Pays the employee's share of group premiums pre-tax |
| Full cafeteria plan | Menu of qualified benefits; employee allocates a benefit allowance |
| Flexible spending account (FSA) | Pre-tax account for out-of-pocket medical or dependent-care costs |
Health FSA Mechanics and Trap
A health FSA is funded by pre-tax salary reduction up to an annual limit (about $3,300 for 2026, indexed). It is use-it-or-lose-it: unused funds are forfeited at year end, except the plan may offer one of these, not both:
- a carryover of a limited amount (roughly $660 for 2026) into the next year, OR
- a 2.5-month grace period to incur eligible expenses.
Exam trap: a plan cannot offer both the carryover and the grace period. Also, the full annual FSA election is available on day one (uniform-coverage rule), even though contributions are deducted over the year.
Qualified benefits include health, dental, vision, group term life (up to $50,000), and disability. Cash, deferred compensation, and most fringe benefits are NOT permitted as cafeteria-plan choices.
Self-Funded (Self-Insured) Plans
Instead of paying premiums to an insurer, a self-funded employer pays employee claims directly out of its own funds, usually with a third-party administrator (TPA) processing claims.
| Feature | Self-Funded Plan |
|---|---|
| Who bears claim risk | The employer |
| Claims paid by | Employer (often via a TPA) |
| Primary regulation | ERISA (generally preempts state insurance law) |
| Catastrophic protection | Stop-loss insurance |
Stop-Loss Insurance
Self-funded employers buy stop-loss coverage so a few large claims do not bankrupt the plan.
| Type | Caps |
|---|---|
| Specific (individual) stop-loss | Maximum the employer pays per covered person |
| Aggregate stop-loss | Maximum the employer pays for the whole group's claims |
Worked example: specific stop-loss is $100,000 per person. A member incurs $260,000 in claims. The employer pays the first $100,000; the stop-loss carrier reimburses the $160,000 above the attachment point. Aggregate stop-loss, often set at about 125% of expected claims, protects against many moderate claims adding up.
Fully Insured vs. Self-Funded: The Key Trade-Off
The central decision is who carries the risk. In a fully insured plan the employer pays fixed premiums and the insurer bears claim risk. In a self-funded plan the employer keeps the cash flow but absorbs the volatility, buying stop-loss to cap the downside.
| Feature | Fully Insured | Self-Funded |
|---|---|---|
| Claim risk | Insurer | Employer |
| Cost | Fixed premium | Variable; claims as incurred |
| State insurance law | Applies | Generally preempted by ERISA |
| Best fit | Smaller, risk-averse employers | Larger employers with stable cash flow |
ERISA Preemption
ERISA (the Employee Retirement Income Security Act) governs most private-employer benefit plans and generally preempts state insurance regulation of self-funded plans. This means a self-funded plan can avoid state-mandated benefits and premium taxes, a major reason large employers self-fund. A crucial exam distinction: self-funded single-employer plans escape state regulation, but self-funded MEWAs (multiple employer welfare arrangements) remain subject to state insurance oversight.
Aggregate Stop-Loss Worked Example
Suppose a plan's expected annual claims are $2,000,000 and the aggregate stop-loss attachment is 125%, or $2,500,000. If total claims reach $2,800,000, the employer funds claims up to $2,500,000 and the aggregate carrier reimburses the $300,000 above the corridor. Specific and aggregate stop-loss are usually purchased together: specific protects against one catastrophic claimant, aggregate against an unexpectedly high volume of ordinary claims.
Administrative-Services-Only (ASO) Contracts
A self-funded employer rarely processes claims itself. It hires a third-party administrator (TPA) or buys an administrative-services-only (ASO) arrangement from an insurer, which adjudicates claims, manages the provider network, and handles paperwork for a fee, while the employer retains the funding obligation. The presence of a familiar insurer's name on the ID card does not change the fact that the employer, not the insurer, is paying the claims.
Section 125 Cafeteria Plan Mechanics
A Section 125 (cafeteria) plan lets employees choose between taxable cash and qualified pre-tax benefits (health premiums, FSA contributions, dependent-care). Because elections are made with pre-tax dollars, they reduce taxable wages — the plan's core advantage. Elections are generally irrevocable for the plan year absent a qualifying status change (marriage, birth, change in employment). A Premium-Only Plan (POP) is the simplest §125 arrangement, covering only the employee's share of premiums.
FSA use-it-or-lose-it trap: A health FSA is funded by pre-tax salary reductions but is use-it-or-lose-it — unspent funds are forfeited at year-end, subject only to a limited carryover (up to a capped amount) or a 2½-month grace period, whichever the plan adopts (not both). Contrast this with an HSA, which rolls over indefinitely and is employee-owned.
Self-Funding and Stop-Loss
Under a self-funded (self-insured) plan, the employer pays claims directly from its own assets rather than buying insurance, often using a third-party administrator (TPA) to process claims. To cap catastrophic exposure the employer buys stop-loss insurance: specific (individual) stop-loss caps the cost of any one claimant, and aggregate stop-loss caps total plan claims for the year. Self-funded plans are governed by ERISA and are generally exempt from state mandates — a key reason large employers self-fund.
Which feature is characteristic of a health flexible spending account (FSA) under a Section 125 plan?
A self-funded plan has specific stop-loss coverage of $150,000 per person. One member incurs $400,000 in covered claims during the year. How much does the stop-loss carrier reimburse for this member?