12.4 Section 125 / Cafeteria Plans and Self-Funding

Employers structure benefits to maximize tax efficiency and control cost. Two key vehicles dominate the national exam: Section 125 cafeteria plans (the pre-tax delivery mechanism for benefits) and self-funding (the employer assuming claims risk under ERISA).

Section 125 Cafeteria Plans

Named for Section 125 of the Internal Revenue Code, a cafeteria plan lets each employee choose between taxable cash and a menu of qualified pre-tax benefits. Because the employee pays for chosen benefits with pre-tax dollars, taxable income drops. Eligible benefits include health, dental, and vision premiums, FSAs, HSAs, and group term life.

FSA vs. HSA

These are frequently confused, so the exam tests the differences directly:

The HSA triple tax advantage: contributions are tax-deductible (or pre-tax), the account grows tax-free, and withdrawals for qualified medical expenses are tax-free. An HSA requires enrollment in a High-Deductible Health Plan (HDHP) and the account stays with the employee even after leaving the job.

Exam trap: Only the HSA requires an HDHP and is owned/portable by the employee. The FSA is employer-owned and subject to use-it-or-lose-it. Mixing these up is a common wrong answer.

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 using a Third-Party Administrator (TPA) to process claims.

ERISA preemption is why self-funding is attractive to large employers: a self-funded single-employer plan is governed by federal ERISA and is generally exempt from state insurance mandates and premium taxes. (Self-funded MEWAs, however, remain subject to substantial state regulation.)

Stop-Loss Insurance

Because a self-funded employer could face a catastrophic claim, it buys stop-loss coverage:

• Specific (individual) stop-loss - caps the employer's liability for any one person's claims.
• Aggregate stop-loss - caps the employer's total claims for the year, often set at a percentage (e.g., 125%) of expected claims.

Worked example: A self-funded plan sets specific stop-loss at $100,000 per person and aggregate stop-loss at 125% of $2,000,000 expected = $2,500,000.

• One employee incurs $160,000 in claims. The employer pays the first $100,000; the stop-loss carrier reimburses the $60,000 above the specific limit.
• Across the year, total plan claims reach $2,750,000. The employer is responsible up to the $2,500,000 aggregate attachment point; the stop-loss carrier covers the $250,000 excess.

Exam tip: Specific stop-loss = per PERSON; aggregate stop-loss = total PLAN. Both protect the employer, not individual employees - employees still receive full benefits regardless.

Section 125 Nondiscrimination Rules

To keep its tax advantages, a cafeteria plan must not discriminate in favor of highly compensated or key employees. The plan must pass IRS eligibility, contribution, and benefit tests. If a plan disproportionately benefits owners and executives, the favorable pre-tax treatment can be lost for those individuals, and the benefits become taxable to them. This rule prevents employers from using Section 125 merely as a tax shelter for the top of the org chart.

Election Irrevocability and Qualifying Life Events

A defining feature of Section 125 is that elections are generally irrevocable for the plan year once made. An employee who elects $2,000 of FSA contributions cannot stop or change that election mid-year simply because they changed their mind. Changes are permitted only on a qualifying life event - marriage, divorce, birth or adoption, death of a dependent, a change in employment status, or a significant change in the cost or coverage of a benefit. This irrevocability is the trade-off for paying with pre-tax dollars.

Funding Continuum: Fully Insured to Self-Funded

Employers sit on a spectrum of risk:

Level-funded plans are a hybrid: the employer pays a steady monthly amount like a premium, but it functions as a self-funded plan with built-in stop-loss, and the employer may receive a refund if claims come in low. This lets smaller employers access self-funding's advantages with predictable cash flow.

The Role of the Third-Party Administrator

A TPA does not bear risk; it performs administrative functions for a self-funded employer - processing and paying claims, maintaining eligibility, issuing ID cards, and handling compliance reporting. An insurer performing only these duties for a self-funded plan acts under an Administrative Services Only (ASO) contract. Recognizing that ASO and TPA arrangements involve no transfer of insurance risk to the administrator is a frequent exam distinction.

Exam trap: Self-funded SINGLE-employer plans enjoy ERISA preemption from state insurance law. Self-funded MEWAs do NOT - they remain heavily state-regulated. Treating all self-funded plans as state-exempt is a classic wrong answer.