12.4 Section 125 / Cafeteria Plans and Self-Funding

Section 125 Cafeteria Plans

A Section 125 plan (named for the Internal Revenue Code section) lets employees choose between taxable cash and qualified pre-tax benefits. Because elections come out of pay before income and FICA taxes, both employee and employer save on payroll taxes. The plan must offer at least one taxable option (cash) and one qualified benefit, which is why it is called a "cafeteria" — employees select from a menu.

Qualified benefits include health, dental, vision, group term life (first $50,000), and disability premiums, plus the spending arrangements below. Deferred compensation (except 401(k) elective deferrals) generally cannot be offered.

FSAs, HSAs, and the Spending Accounts

Cafeteria plans commonly house flexible spending and savings accounts:

The health FSA is subject to a use-it-or-lose-it rule: unused funds are forfeited unless the plan adopts a limited carryover or a grace period (up to 2.5 months). An HSA requires enrollment in a qualified high-deductible health plan (HDHP) and, unlike an FSA, the balance carries forward and belongs to the employee permanently.

Worked Tax Example

Suppose an employee earns $60,000 and elects $3,000 of health premiums pre-tax through a Section 125 plan. The $3,000 is excluded from taxable wages, so income is taxed on $57,000.

• Combined income + FICA rate assumed at 30%.
• Tax saved = $3,000 x 0.30 = $900 for the employee.
• The employer also avoids its 7.65% FICA match on the $3,000: 3,000 x 0.0765 = $229.50 saved.

This pre-tax leverage is the core appeal of cafeteria plans. Trap: mid-year election changes are barred unless the employee has a qualifying life event (marriage, birth/adoption, divorce, change in employment status, or loss of other coverage).

Self-Funding and Stop-Loss

Under a self-funded (self-insured) plan, the employer pays claims directly from its own assets instead of buying a fully insured policy. A third-party administrator (TPA) processes claims, and an administrative-services-only (ASO) arrangement may use an insurer's network without transferring risk.

To cap exposure, self-funded employers buy stop-loss insurance:

• Specific (individual) stop-loss — reimburses claims on any one person above an attachment point (e.g., $75,000).
• Aggregate stop-loss — reimburses total plan claims above a threshold (often 125% of expected claims).

Self-funded ERISA plans are largely exempt from state benefit mandates and premium taxes, a key reason large employers self-fund. Fully insured plans, by contrast, must follow state mandates because the insurer bears the risk.

Premium-Only Plans and Election Mechanics

The simplest Section 125 arrangement is a premium-only plan (POP), which lets employees pay their share of group insurance premiums with pre-tax dollars and nothing more. A full flexible benefit plan adds FSAs and a menu of optional benefits funded with employer flex credits or employee salary reductions.

Election rules are strict:

• Employees choose benefits before the plan year begins; the election is then locked.
• Mid-year changes require a qualifying life event (marriage, divorce, birth or adoption, death of a dependent, change in employment status, or loss of other coverage).
• A change must be consistent with the event — e.g., adding a spouse after marriage, not arbitrarily increasing an FSA.

Nondiscrimination testing prevents the plan from favoring highly compensated or key employees; if it fails, those employees lose the tax exclusion while rank-and-file employees keep it.

Self-Funding Trade-offs and a Stop-Loss Worked Example

Self-funding offers cash-flow advantages (the employer holds reserves and earns interest), exemption from state premium taxes and benefit mandates under ERISA, and access to its own claims data. The trade-off is risk and volatility: a few catastrophic claims can strain cash flow, which is why stop-loss is essential.

Worked example: An employer self-funds with a specific stop-loss attachment point of $100,000 and an aggregate attachment of 125% of $2,000,000 expected claims = $2,500,000. If one employee incurs $340,000 in claims, specific stop-loss reimburses $340,000 - $100,000 = $240,000. Separately, if total plan claims reach $2,750,000, aggregate stop-loss reimburses $2,750,000 - $2,500,000 = $250,000. The two coverages work together: specific caps any single large claim, aggregate caps the total.

HSA Rules and Fully Insured vs. Self-Funded Recap

The HSA deserves special attention because it blends a Section 125 cafeteria election with a portable savings vehicle. To contribute, the individual must be enrolled in a qualified high-deductible health plan (HDHP) and have no disqualifying coverage. Contributions are tax-deductible (or pre-tax through the cafeteria plan), grow tax-deferred, and come out tax-free for qualified medical expenses. Unlike an FSA, the balance rolls over indefinitely and follows the employee to a new job or into retirement.

Finally, recap the funding-model contrast that exams love:

• Fully insured — insurer bears risk, employer pays fixed premium, state mandates and premium taxes apply.
• Self-funded — employer bears risk and pays claims, uses a TPA/ASO and stop-loss, and is ERISA-exempt from state mandates.

Match the clue in the stem: "employer pays claims from its own assets" signals self-funding; "fixed monthly premium to an insurer" signals fully insured.