12.4 Section 125 / Cafeteria Plans and Self-Funding

Employers fund and structure health benefits in ways that affect taxation and risk. The exam tests Section 125 cafeteria plans (how employees choose and pay for benefits pre-tax) and self-funding (who actually bears the claims risk).

Section 125 Cafeteria Plans

A cafeteria plan under Internal Revenue Code Section 125 lets employees choose between taxable cash and a menu of qualified (nontaxable) benefits, paying for chosen benefits with pre-tax dollars. Because contributions are pre-tax, employees lower their taxable income, and the employer reduces payroll taxes.

Qualified benefits typically include health insurance premiums, dental/vision, group term life (up to limits), disability, and flexible spending accounts. Deferred-compensation plans like 401(k)s are generally not part of a cafeteria plan (one narrow exception aside).

The tax mechanics are the whole point. A pre-tax dollar run through a Section 125 plan escapes federal income tax and, importantly, FICA (Social Security and Medicare) tax as well, which an after-tax purchase cannot. That FICA savings benefits the employer too, since the employer matches FICA. The trade-off the exam likes to surface is that lowering FICA wages can slightly reduce the employee's future Social Security benefit base — a real but usually minor cost.

Types of Section 125 Arrangements

FSA traps: an FSA is generally use-it-or-lose-it — unused funds are forfeited at year-end, though the IRS permits an optional carryover (a limited dollar amount) or a 2.5-month grace period, but not both. Elections are fixed for the year unless a qualifying change in status (marriage, birth, change in employment) occurs.

Worked Example: Pre-Tax Savings

Priya earns $60,000 and elects $3,000 of pre-tax FSA and premium contributions through a Section 125 plan. Her combined marginal tax rate (federal + FICA + state) is 30%.

• Taxable income drops from $60,000 to $57,000.
• Tax savings = $3,000 × 0.30 = $900.

The $3,000 buys the same benefits but costs Priya only $2,100 after tax. Trap: if Priya does not incur $3,000 of eligible FSA expenses (beyond any allowed carryover/grace period), she forfeits the unused balance — the use-it-or-lose-it rule.

Self-Funding (Self-Insurance)

Under a self-funded (self-insured) plan, the employer pays claims directly out of its own assets instead of buying a fully insured group policy. The employer bears the underwriting risk and gains cash-flow and design flexibility. Self-funded plans are governed largely by ERISA and are generally exempt from state insurance mandates and premium taxes.

This ERISA preemption is a frequent exam point: because a true self-funded plan is regulated as an employee benefit plan under federal law, states cannot force it to cover specific state-mandated benefits or collect premium tax on it. That regulatory freedom, plus keeping the reserves the insurer would otherwise hold, is why large employers self-fund.

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

• Specific (individual) stop-loss – caps the employer's liability for one person's claims above a set attachment point.
• Aggregate stop-loss – caps the employer's total claims for the year above an attachment point.

Fully Insured vs. Self-Funded

Worked aggregate stop-loss: an employer expects $1,000,000 of claims and buys aggregate stop-loss at a 125% attachment point ($1,250,000). If actual claims hit $1,400,000, the stop-loss carrier reimburses the $150,000 above $1,250,000; the employer funds the first $1,250,000.

Worked specific stop-loss: the same employer sets a specific attachment point of $75,000 per person. If one employee incurs $210,000 of claims in the year, the employer pays the first $75,000 and the stop-loss carrier reimburses the $135,000 excess for that individual. Note that dollars reimbursed under specific stop-loss still count toward the employer's total claims, which can in turn trigger the aggregate layer — the two coverages stack, they do not duplicate.