What Does Section 125 Mean For Your Health?

Colorado’s Blue Ribbon Commission for Health Care Reform is considering recommending that Colorado employers be required to establish “125 health care plan choices.” This means big tax benefits for small employers that don’t set up their own group health insurance plan.Section 125 plans — so-named for a specific tax law — are more commonly called “cafeteria plans.” They have historically been the province of big companies that want to provide a wide array of benefit choices to a diverse workforce. But, they also provide a backdoor way for employees at companies that don’t provide group health insurance to get the same tax benefits that apply to employer-provided plans.

There are many kinds of Section 125 plans but the simplest is the health insurance premium-only plan.

Under this scenario, the employer deducts from pre-tax wages an amount equal to the employee’s health insurance premium. The employee provides proof of payment of the health insurance premium to the employer. In return, he/she gets a tax-free reimbursement check for the premium payment. Tax-wise, it has the same effect as trading a smaller paycheck for employer-provided health insurance. The employer incurs only some modest additional payroll processing costs.

More elaborate Section 125 health care plans are also possible.

A “use it or lose it” fund to reimburse out-of-pocket health expenses can be established with a payroll deduction. The employer doesn’t have to contribute anything at all. However, some employers opt to contribute a flat dollar amount each month to an employee’s plan balance (also on a pre-tax basis). In this way, an employer can help with an employee’s health insurance costs without making a symbolic commitment to increase the amount contributed if health insurance premiums go up.

So in effect, employer-established Section 125 health care plans reap the benefits of both tax-deductible self-employed health insurance premiums and the old tax law that allowed unlimited medical expense deductions.

If an employer has a Section 125 plan, every employee has to have the option to participate —  though there are a few exceptions since this is byzantine federal tax law.

While there are some limits on what kind of health care insurance can be purchased, there is no requirement that employees spend the payroll  deduction on the same thing, or in the same amount.

Employees can use the money for COBRA payments, to pay for any third-party health insurance, or to set up a fund to reimburse himself for out of pocket expenses incurred under his spouse’s health care plan that also covers him. He can also elect not to participate in a plan at all.

The upside is that it gives employers and employees flexibility and allows employers to take an incremental approach towards helping employees with health care costs.

The down side is that it allows employers to indirectly finance less-regulated health insurance plans targeted at individuals and families effectively gutting state law that protects policy holders.

These plans may also allow management to get more comprehensive coverage than rank and file workers, escaping limits that require employers to provide for their employees if they want tax benefits for themselves.

Obviously, there are details. This is federal tax law, after all. But this is the basic premise of a 125 plan — one of the plans under consideration by the state health care commission.

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Andrew Oh-Willeke

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