12.4 Section 125 / Cafeteria Plans and Self-Funding

Employers structure benefits for tax efficiency and cost control. Section 125 cafeteria plans create the pre-tax wrapper around employee benefit choices, while self-funding changes who bears the claims risk. Both topics carry several reliable exam points about taxation, ERISA, and stop-loss.

Section 125 Cafeteria Plans

A cafeteria plan (named for IRS Code Section 125) lets employees choose among at least one taxable benefit (cash) and one or more qualified pre-tax benefits.

Key point: The pre-tax treatment is what makes contributory group health affordable — the employee's share runs through the Section 125 plan and reduces taxable income.

Flexible Spending Accounts (FSAs)

An FSA is a common cafeteria-plan component funded by pre-tax salary reduction to reimburse qualified medical (or dependent-care) expenses.

Worked Numeric

An employee elects $2,000 to a health FSA. In a 24% federal bracket plus 7.65% FICA, the pre-tax election saves roughly 0.3165 x $2,000 = about $633 in taxes. But if she spends only $1,700, the remaining $300 is forfeited (absent a carryover/grace provision) — the classic use-it-or-lose-it trap.

Contrast: An HSA (paired with a qualified high-deductible plan) is owned by the employee, rolls over indefinitely, and is portable — unlike the employer-tied, forfeitable FSA.

Self-Funded (Self-Insured) Plans

Instead of buying insurance, a large employer may self-fund: it pays claims out of its own assets, often using a third-party administrator (TPA) to process claims.

Because ERISA preempts state insurance regulation of self-funded plans, these plans escape state-mandated benefits and premium taxes — a major reason large employers self-fund. ERISA still requires a Summary Plan Description, fiduciary conduct, and a claims/appeals process.

Stop-Loss Insurance

A self-funded employer caps its risk by buying stop-loss (excess) insurance, which reimburses claims above a chosen attachment point.

Worked Example

A plan buys specific stop-loss with a $100,000 attachment. If one employee incurs $260,000 in claims, the employer pays the first $100,000 and stop-loss reimburses the $160,000 excess. Separately, if total plan claims exceed the aggregate attachment (say 125% of the $2,000,000 expected = $2,500,000), aggregate stop-loss covers the excess over $2,500,000.

Trap: Stop-loss insures the employer, not the employee. The plan remains self-funded and ERISA-governed; employees still see a normal benefit plan.

Why Employers Build Benefits This Way

Step back and connect the two halves of this section to an employer's two goals: tax efficiency and cost control. A Section 125 cafeteria plan delivers the tax efficiency by letting employees pay for qualified benefits with pre-tax dollars, which lowers both the employee's taxable wages and the employer's payroll-tax base. The plan must offer at least one taxable choice (cash) alongside the qualified pre-tax benefits, which is what distinguishes a true cafeteria plan from a simple list of benefits.

The exam wants you to recognize that the pre-tax wrapper is exactly what makes a contributory group health plan affordable — the employee's share runs through the Section 125 plan and never appears as taxable income.

Within the cafeteria plan, the flexible spending account is the most tested component and the source of the use-it-or-lose-it trap. An FSA is funded by pre-tax salary reductions, the full annual election is available from the first day under the uniform-coverage rule, and unused balances are generally forfeited at year-end unless the plan adopts either a limited carryover or a short grace period — but not both. Contrast the FSA with a health savings account, which the employee owns, which rolls over indefinitely, and which travels with the employee when they leave; the HSA must be paired with a qualified high-deductible health plan.

Self-Funding and Stop-Loss

The cost-control half is self-funding. A large employer that self-funds pays claims from its own assets, usually through a third-party administrator, rather than buying an insured product. The pivotal exam fact is that ERISA preempts state insurance regulation of self-funded plans, so they escape state-mandated benefits and premium taxes — a major reason large employers choose this route — while still owing ERISA duties such as a Summary Plan Description, fiduciary conduct, and a claims-and-appeals process.

To cap the risk of self-funding, the employer buys stop-loss insurance. Specific (individual) stop-loss reimburses claims above a per-person attachment point, while aggregate stop-loss protects when total plan claims exceed a whole-plan threshold, often set near 125 percent of expected claims.

Exam Trap: Stop-loss insures the employer, not the employee. The plan remains self-funded and ERISA-governed, and employees still experience an ordinary benefit plan with no awareness of the stop-loss layer.