12.4 Section 125 / Cafeteria Plans and Self-Funding

Section 125 Cafeteria Plans

A cafeteria plan is an employer benefit plan authorized by Internal Revenue Code Section 125 that lets employees choose among a menu of benefits using pre-tax dollars. Employees pick from at least one taxable benefit (usually cash/salary) and one or more qualified (nontaxable) benefits such as health insurance, dental, vision, group term life (up to $50,000), and flexible spending accounts.

The tax advantage is the point: contributions are made through salary reduction before income and FICA taxes, lowering the employee's taxable income. To enjoy this pre-tax treatment without IRS penalties, the plan must meet nondiscrimination rules — it cannot favor highly compensated or key employees.

Flexible Spending Accounts and the Use-It-or-Lose-It Rule

A common cafeteria-plan component is the Flexible Spending Account (FSA) — a health FSA for medical expenses and a dependent-care FSA for childcare. Employees fund FSAs with pre-tax salary reductions.

The classic tested trap is the 'use-it-or-lose-it' rule: unused FSA funds are generally forfeited at year-end. The IRS permits employers to offer either a grace period of up to 2.5 months or a carryover of a limited amount (indexed annually) — but not both. Health FSAs have an annual contribution limit set by the IRS and indexed each year.

HSAs vs. FSAs (Frequently Confused)

A Health Savings Account (HSA) must be paired with a qualified High-Deductible Health Plan (HDHP). Unlike an FSA, the HSA is owned by the employee, the funds roll over year to year, and the account is portable when the employee leaves. HSAs are triple-tax-advantaged: pre-tax contributions, tax-free growth, and tax-free qualified withdrawals.

Key distinctions the exam tests:

• FSA — employer-established, generally use-it-or-lose-it, not portable.
• HSA — employee-owned, requires an HDHP, rolls over, portable, has IRS contribution limits and catch-up contributions at age 55.

Withdrawing HSA funds for non-qualified expenses before age 65 triggers income tax plus a 20% penalty; after 65, non-qualified withdrawals are taxed but not penalized.

Self-Funded (Self-Insured) Plans and Stop-Loss

In a self-funded plan, the employer pays employee claims directly out of its own funds rather than buying a fully insured policy. The employer bears the risk and often hires a third-party administrator (TPA) or uses an administrative-services-only (ASO) arrangement to process claims.

Self-funded single-employer plans are regulated primarily under federal ERISA and are largely exempt from state insurance mandates (the ERISA preemption) — a key reason large employers self-fund. To cap their risk, employers buy stop-loss insurance:

• Specific (individual) stop-loss — reimburses claims on one person above a set dollar attachment point.
• Aggregate stop-loss — reimburses when total plan claims exceed an aggregate threshold (often ~125% of expected).

A MEWA (multiple-employer welfare arrangement) that self-funds is subject to greater state regulation than a single-employer self-funded plan because of historical solvency abuses. The exam point: a self-funded single-employer plan enjoys broad ERISA preemption of state mandates, while a self-funded MEWA does not get the same shield and faces state oversight.

Self-funding's advantages — avoiding state premium taxes and mandates, holding the reserve (cash flow), and customizing benefits — must be weighed against the employer's exposure to large claims, which stop-loss is purchased to contain.

Worked Example: Pre-Tax Savings and Stop-Loss Attachment

An employee elects $2,400/year into a health FSA through salary reduction. If her combined income + FICA marginal rate is 30%, the pre-tax election saves about $2,400 × 0.30 = $720 in taxes versus paying those medical costs with after-tax dollars. But if she spends only $2,000 and her plan offers no carryover/grace, she forfeits $400 under use-it-or-lose-it.

Stop-loss example: an employer's self-funded plan has a specific stop-loss attachment point of $75,000 per person. An employee incurs $210,000 in claims. The employer pays the first $75,000; the specific stop-loss carrier reimburses the $135,000 excess ($210,000 − $75,000), protecting the employer from the catastrophic individual claim.

Worked Example: Aggregate Stop-Loss

The same employer's expected annual claims are $4,000,000, and its aggregate stop-loss attaches at 125% of expected = $5,000,000. If total plan claims for the year reach $5,400,000, the aggregate carrier reimburses the $400,000 above the $5,000,000 attachment point. Specific and aggregate stop-loss are often purchased together — specific protects against one huge claim, aggregate against many moderate claims piling up.

Group Life Tax Crossover Note

Because cafeteria plans can include group term life insurance, remember the related tax rule that appears on the national exam: employer-paid group term life is tax-free to the employee on the first $50,000 of coverage. The cost of coverage above $50,000 is imputed income to the employee using the IRS Table I rates and is subject to income and FICA taxes — even though the premium is employer-paid. This $50,000 threshold is one of the most-tested numbers in employer-plan taxation.