Section 125 Plans: Policy Implications for States

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A growing number of states are expressing interest in reducing the number of uninsured workers and making their health coverage more affordable by requiring or encouraging employers to set up Section 125 plans—also referred to as “cafeteria plans.” These plans refer to Section 125 of the U.S. Internal Revenue Code, which establishes rules related to taxable and non-taxable benefits offered by employers. Section 125 plans reduce the effective cost of health care coverage for many employees (depending on their total income and family situation) by allowing them to purchase coverage on a pre-tax basis. This administrative mechanism reduces both employees’ and employers’ share of Medicare and Social Security taxes, as well as employee income taxes and employer unemployment payments. 

Section 125 plans are an attractive option to state policy makers because they are a very low-cost way to make coverage more affordable. (States with an income tax that is tied to the federal tax forego a small amount of revenue.) This tax shelter has been available to small businesses for years, so the question is how to increase participation without: a) running afoul of other legal issues; or b) creating an onerous burden on small businesses. States have made it easier for small businesses to participate by: a) conducting outreach and education; b) helping them with forms and paperwork; c) offering mini-grants to help small businesses set up plans; and d) combining a requirement to use a Section 125 plan with a premium subsidy to make the package more attractive. For employees that take advantage of the Section 125 plan, savings on health premiums are typically around 25 percent, but vary based on income and family size from a negative tax liability (for those with very low incomes who benefit from the Earned Income Tax Credit) to a 50 percent savings on premiums.
Legal and Policy Issues[i]
Several federal laws affect implementation of these Section 125 plans. Because these plans qualify as “group health plans” under the Internal Revenue Code, they appear subject to employer notice provisions under the Consolidated Omnibus Budget Reconciliation Act (COBRA), as well as nondiscrimination and benefit design requirements under the Health Insurance Portability and Accountability Act (HIPAA). It appears that Section 125 plans are not subject to the Employee Retirement Income Security Act(ERISA), however, as long as employers do not promote purchase of specific individual health insurance policies. Further, state policies that require employers to adopt Section 125 plans should not be preempted by ERISA as long as the state law applies to employers and does not refer to employer-sponsored plans.
To minimize the potential for problems under ERISA and the tax code, states that are considering a Section 125 cafeteria plan requirement should draft that mandate very broadly. States should also avoid terms such as “employer group,” “employer-sponsored,” and “group plans.” States may simply choose to refer to these plans as “plans available under a cafeteria plan.” States may also wish to consider providing model cafeteria plan materials and technical assistance to employers, as well as model COBRA notices.
Exchanges or Connectors that offer a selection of competing health coverage choices offer an advantage to states seeking to implement Section 125 plans. These exchanges help minimize the potential that individually purchased health insurance could be interpreted as an employer-sponsored plan.
Massachusetts’ Experience
Massachusetts’ experience in implementing Section 125 plans offers lessons to other states considering a similar approach. As part of Massachusetts’ comprehensive 2006 health reform law, employers with 11 or more full-time workers are required to establish Section 125 plans that enable workers to purchase health insurance with pre-tax dollars regardless of whether or not employers offer coverage to their workers or contribute to the premium. Massachusetts also established the Commonwealth Health Insurance Connector Authority to help small employers and individuals purchase affordable insurance, and to help all employers facilitate their offering of Section 125 plans. As part of the reform package, adults in the state were required to purchase insurance if they could afford to do so.
While most employers report a positive experience with Massachusetts’ Section 125 plans, take up rates have been relatively low, especially during the initial implementation period. Massachusetts has found wide variation in the education and outreach offered by employers about the benefit of Section 125 plans. As of November 2008, just 1,129 of the 14,879 adults purchasing coverage through the Connector without an employer contribution did so through Section 125 plans. While this number is relatively modest, there has been a steady increase in the numbers of people using a Section 125 plan when purchasing their health insurance.
The state’s experience thus far offers several lessons for other states, including the importance of frequent communication with employers to keep them engaged, the need to target specific types of employers and individuals who have the most to benefit from Section 125 plans, the necessity of simplifying the administrative process, and the importance of providing easily accessible, jargon-free outreach materials that employers can give to workers.[ii]
Other States Explore Section 125 Plans
A number of other states have considered or are implementing Section 125 plans as part of reform efforts aimed at reducing the number of uninsured. For example, Minnesota’s comprehensive health care reform legislation, passed in 2008, includes a provision that employers with 11 or more full-time workers who do not offer group health insurance are required to establish a Section 125 plan so that employees can purchase health insurance with pre-tax dollars.[iii] Minnesota has taken an additional step by establishing a $1 million fund to help cover certain employer costs associated with establishing Section 125 plans.


Continue reading on: Overview of State Approaches to Section 125 Policies Designed to Expand Coverage


[i] Adapted from Butler, P. Employer Cafeteria Plans: States’ Legal and Policy Issues, California HealthCare Foundation, October 2008.
[ii] Carey, B. “The Section 125 Plan Requirement and Massachusetts Employers: Experiences, Reactions, and Initial Results,” Commonwealth Health Insurance Connector Authority, SCI Summer Workshop for State Officials, July 2008.
[iii] While Minnesota “requires” participation in Section 125 plans, employers can opt out of this requirement with no penalty.