12.4 Section 125 / Cafeteria Plans and Self-Funding

Section 125 / Cafeteria Plans and Self-Funding

Employers can structure benefits to deliver them with favorable tax treatment and to control cost. Two concepts dominate this section of the exam: Section 125 cafeteria plans (how benefits are chosen and paid for pre-tax) and self-funding (how the employer finances claims). Both are about funding mechanics, not new benefits.

A Section 125 cafeteria plan, named for the Internal Revenue Code section, lets employees choose among a menu of qualified benefits and pay for elected benefits with pre-tax salary reductions, lowering taxable income.

What a cafeteria plan can and cannot include

A cafeteria plan must offer at least one taxable option (typically cash) and one qualified nontaxable benefit. Common menu items:

• Health, dental, and vision premiums (pre-tax)
• Flexible Spending Accounts (FSAs) — health-care and dependent-care
• Group term life up to $50,000
• Health Savings Account (HSA) contributions

Prohibited inside a Section 125 plan: long-term care insurance, most scholarships, and deferred-compensation arrangements (except 401(k) elective deferrals). Knowing what is excluded is a frequent test point.

Premium Only Plans (POP) and election timing

The simplest Section 125 arrangement is a Premium Only Plan (POP), where the only pre-tax benefit is the employee's share of health premiums. A full flexible benefit plan adds FSAs and a menu of choices.

Elections are generally irrevocable for the plan year—once an employee chooses, they cannot change until the next open enrollment unless a qualifying life event occurs (marriage, divorce, birth/adoption, death of a dependent, or a change in employment status). This irrevocability rule, and its life-event exceptions, is a favorite exam point: an employee who simply changes their mind mid-year cannot adjust their FSA election.

Nondiscrimination testing

Because Section 125 plans deliver tax advantages, the IRS requires nondiscrimination testing to ensure they do not disproportionately favor highly compensated or key employees. If a plan is found discriminatory, the favored employees lose the pre-tax treatment and must include the benefit value in taxable income, while rank-and-file employees keep their tax advantage.

For the exam, the takeaway is the purpose: the tax break is conditioned on broad, equitable availability across the workforce—not a perk steered to executives.

FSAs and the use-it-or-lose-it rule

A health FSA lets an employee set aside pre-tax dollars for qualified medical expenses. The classic exam point is use-it-or-lose-it: unused funds are generally forfeited at year-end. The IRS permits employers to offer one of two reliefs—either a grace period of up to 2.5 months or a carryover of a limited amount—not both.

Worked numeric: An employee elects $2,400 into a health FSA ($200/month). Being pre-tax in a 25% bracket, the election saves about $600 in income tax. If the employee spends only $2,000 and the plan offers a $640 carryover, $400 carries to next year and nothing is forfeited; with no carryover/grace period, the $400 is lost.

HSA vs. FSA quick contrast

Examiners contrast these because both are pre-tax health accounts:

Key trap: an HSA requires enrollment in a qualified HDHP, the funds belong to and follow the employee, and balances roll over—unlike an FSA.

Taxation of cafeteria-plan and employer health benefits

The tax mechanics are heavily tested. Employer-paid group health premiums are deductible to the employer and not taxable income to the employee. Employee contributions made through a Section 125 plan are pre-tax, reducing both income tax and FICA wages.

Group term life is special: employer-paid coverage up to $50,000 is tax-free to the employee, but the cost of coverage above $50,000 is imputed income taxed via IRS Table I rates. Disability income benefits are tax-free if the employee paid the premium with after-tax dollars, but taxable if the employer paid the premium.

Self-funding and stop-loss

Instead of buying a fully insured group policy, a large employer may self-fund (self-insure): it pays employee claims out of its own assets, often using a third-party administrator (TPA) to process claims and an Administrative Services Only (ASO) arrangement.

Self-funded plans are regulated federally under ERISA and are largely exempt from state insurance mandates—a tested distinction. To cap catastrophic risk, employers buy stop-loss insurance:

• Specific (individual) stop-loss — reimburses claims on one person above a set attachment point (e.g., $50,000).
• Aggregate stop-loss — reimburses total plan claims above a percentage of expected claims (e.g., 125%).

When self-funding makes sense — a worked example

Self-funding suits large, financially stable employers with predictable claims and cash flow to absorb timing swings. The employer keeps the float and dodges state premium taxes and benefit mandates, but bears the volatility risk—hence stop-loss.

Worked numeric: A self-funded plan expects $2,000,000 in annual claims and buys aggregate stop-loss at 125%. The employer is responsible up to $2,500,000 (125% × $2,000,000); claims above that are reimbursed by the stop-loss carrier. If it also holds specific stop-loss at $100,000, any single member's claims above $100,000 are reimbursed regardless of the aggregate total.