12.4 Section 125 / Cafeteria Plans and Self-Funding

Section 125 / Cafeteria Plans and Self-Funding

Section 125 Cafeteria Plans

A cafeteria plan, authorized by Internal Revenue Code Section 125, lets employees choose among a menu of benefits using pre-tax dollars. Employees select from at least one taxable benefit (usually cash) and one or more qualified nontaxable benefits (health, dental, disability, group term life up to $50,000, dependent care).

Because contributions come out before income and payroll taxes, the employee lowers taxable income — the central exam point. The plan must offer a genuine choice between taxable and nontaxable benefits; if it offered only nontaxable benefits it would not be a true cafeteria plan. Common structures include premium-only plans (POPs), flexible spending arrangements, and full flex-credit menus where the employer grants credits the employee allocates.

Why ERISA Preemption Matters

Because a self-funded plan is governed by ERISA rather than state insurance law, it is generally exempt from state benefit mandates (such as a state requirement to cover a specific treatment). This federal preemption is a key reason large employers self-fund — they gain uniform, nationwide plan design. The exam tests that self-funded/ASO plans escape most state mandates while fully insured plans must comply with them.

Worked Scenario: Pre-Tax Savings

An employee earning $60,000 elects $5,000 of benefits through a Section 125 plan. Those dollars are excluded from income and payroll taxes, so taxable wages drop to $55,000. At a combined 30% rate, the pre-tax election saves about $1,500 versus paying for the same benefits with after-tax dollars — the central selling point of a cafeteria plan.

Dependent Care FSA and Qualified Benefits

A cafeteria plan may include a dependent care FSA (pre-tax reimbursement of child or elder care, capped annually) alongside the health FSA. Permitted qualified benefits include accident and health coverage, group term life up to $50,000, disability, and HSAs; deferred compensation and long-term care generally may not be offered through a Section 125 plan. The exam tests which benefits are eligible: group term life above $50,000 creates imputed income and cannot be fully pre-taxed, and LTC is excluded from cafeteria menus.

Comparing HSA, FSA, and HRA Ownership

The exam repeatedly contrasts the three reimbursement accounts on ownership and portability. An HSA is owned by the employee, requires enrollment in a qualified HDHP, rolls over without limit, and travels with the worker to a new job or retirement. A health FSA is employer-sponsored, subject to use-it-or-lose-it (with a limited carryover or grace period, never both), and is not portable. An HRA is employer-funded only, and the employer decides whether unused amounts carry forward; it too is not portable. If a question asks which account the employee keeps after leaving the job, the answer is the HSA.

Flexible Spending Accounts (FSAs) and the 'Use-It-or-Lose-It' Trap

A Flexible Spending Account (FSA) is funded by pre-tax salary reductions to reimburse eligible medical or dependent-care expenses. The classic exam trap is the use-it-or-lose-it rule: funds not spent by the end of the plan year are generally forfeited, though plans may offer either a limited carryover (a capped amount, indexed) or a grace period (up to 2.5 extra months) — never both.

Worked numeric: an employee elects $2,000 to a health FSA and spends $1,700 on eligible expenses by year-end. With a $640 carryover feature, $300 carries forward and nothing is lost. Without any carryover or grace period, the unspent $300 is forfeited to the employer.

Self-Funded (Self-Insured) Plans

In a self-funded plan the employer pays claims out of its own funds rather than buying a fully insured policy. The employer bears the underwriting risk and gains cash-flow and design flexibility, and the plan is governed federally by ERISA rather than by state insurance law (the ERISA preemption). To cap exposure, employers buy stop-loss insurance:

• Specific (individual) stop-loss — reimburses claims on any one person above a set attachment point (e.g., $100,000).
• Aggregate stop-loss — reimburses total group claims above a percentage of expected claims (e.g., 125%).

Worked numeric: expected annual claims are $2,000,000 and aggregate stop-loss attaches at 125% = $2,500,000. If actual claims hit $2,750,000, the stop-loss carrier reimburses the $250,000 excess; the employer pays the first $2,500,000. Stop-loss lets even mid-sized employers self-fund without risking catastrophic single-year losses.

ASO and Fully Insured vs. Self-Funded

Many self-funded employers hire an insurer or third-party administrator under an Administrative Services Only (ASO) arrangement to process claims and provide a provider network, while the employer keeps the claims risk. Contrast this with a fully insured plan, where the insurer takes the risk, sets the premium, and is regulated by the state.

Exam trap: in a self-funded/ASO plan the carrier is not at risk for claims — it only administers. Self-funding tends to suit larger, financially stable employers with predictable claims, while small employers usually choose fully insured coverage to transfer risk. Watch for questions that ask which party bears the risk: under ASO it is the employer; under a fully insured plan it is the insurer.