The Small Business Owner’s Guide to Starting a Section 125 Cafeteria Plan

Section 125 Plans vs. FSAs

Unlike flexible spending accounts (FSAs), which are a type of reimbursement account that allows employees to set aside pre-tax dollars to pay for eligible healthcare or dependent care expenses, a cafeteria plan allows employees to use pre-tax dollars to pay for a much wider range of benefits.

Optimizing Tax Savings Using a Section 125 Plan

Integrating a Section 125 cafeteria plan with a health savings account (HSA) can be a powerful way to help your employees save money on healthcare expenses and build up savings for future healthcare needs.

Here are some best practices for integrating these two types of plans:

• Offer both plans. To integrate a Section 125 plan with an HSA, you will need to offer both plans to your employees. Your Section 125 plan can be used to pay for eligible healthcare expenses, such as insurance premiums and deductibles, while your HSA can be used to save for future healthcare expenses.

• Educate your employees. Just offering the plan isn’t enough. You also need to put emphasis on communication. Provide clear and concise communications about the benefits offered, enrollment procedures, contribution limits, and other important details. You may also want to provide educational materials or hold informational sessions to help your employees understand how the plans work and how they can use them to save money on healthcare expenses. Try to communicate benefits information throughout the year, and not just during open enrollment and onboarding. Use a variety of media, and if appropriate, provide materials in Spanish and other languages as needed.
  
  Learn more: Best Practices for Communicating Employee Benefits

• Coordinate contributions. When integrating a Section 125 plan with an HSA, it’s important to coordinate contributions to ensure that employees don’t exceed the contribution limits for either plan. You will need to establish contribution limits for both plans and ensure that employees are aware of these limits. You may also want to provide tools or calculators to help employees determine the optimal contribution amounts for each plan.

          Learn more: Higher Communication Limits Allow You To Save Even More in Taxes

• Monitor and administer the plans. Once your plans are in place, you will need to monitor and administer them on an ongoing basis. This includes processing employee contributions, coordinating with your plan administrator, and ensuring that your plans remain compliant with IRS regulations. You may also want to periodically review your plans to ensure that they are meeting the needs of your employees and your business.

By integrating your HSA offering with a Section 125 plan, you can provide your employees with a powerful tool for managing healthcare expenses and building up savings for future needs.

Types of Cafeteria Plans

There are several different types of cafeteria plans that employers can offer to their employees.  Here are some of the most common types of cafeteria plans

• Health savings account (HSA). An HSA is a tax-advantaged savings account that can be used to pay for eligible healthcare expenses. To be eligible for an HSA, an employee must have a high-deductible health plan (HDHP). HSAs allow employees to save money on taxes while also building up savings for future healthcare expenses.
• Premium-only plan (POP). A POP allows employees to pay for their share of health insurance premiums with pre-tax dollars. These plans only cover insurance premiums and no other expenditures.This can help employees save money on taxes and reduce their taxable income.
• Health flexible spending account (FSA). An FSA allows employees to set aside pre-tax dollars to pay for eligible healthcare expenses, such as deductibles, copays, and coinsurance. Employees can use FSA dollars to pay pre-tax a wide range of other healthcare expenses, including prescription drugs, glasses/contact lenses, orthodontia, dental care, mental health treatment, and even medically necessary alternative medical treatments such as acupuncture and chiropractic care.
• Dependent care flexible spending account (DCFSA). A DCFSA allows employees to set aside pre-tax dollars to pay for eligible dependent care expenses, such as daycare or afterschool care for children under the age of 13, or elderly dependents who are unable to care for themselves.
• Premium reimbursement arrangements (PRA). A PRA is similar to a POP, but it allows employees to be reimbursed for their share of health insurance premiums rather than paying for them with pre-tax dollars. PRAs can be used in conjunction with other types of cafeteria plans to provide employees with additional flexibility.
• Section 125(e) Qualified Small Employer Health Reimbursement Arrangement (QSEHRA). A QSEHRA is a type of health reimbursement arrangement (HRA) that allows small employers to reimburse employees for eligible healthcare expenses, including premiums for individual health insurance policies. QSEHRAs are available to employers with fewer than 50 full-time equivalent employees who do not offer a group health plan.

Click here for more information about HRAs, (including QSEHRAs) and how to start one.

It’s important to note that not all types of cafeteria plans are available to all employers, and eligibility requirements may vary depending on a variety of factors.

For any employers that we are helping with health insurance or health sharing benefits, we also help them with setting up their Section 125 benefits, if appropriate. For a free, no-obligation consultation on your specific situation, contact a Personal Benefits Manager.

Section 125 Compliance

Non-Discrimination Rules

To ensure that Section 125 plans benefit all employees fairly, Section 125 plan sponsors must adhere to these non-discrimination provisions.

These rules prevent business owners from setting up tax-advantaged plans that benefit themselves and senior management only, leaving rank-and-file employees out.

Should a plan violate these rules in any given year, they may be deemed discriminatory. If that happens, any benefits that were preferentially given will be considered taxable income for those high-earning or key employees who received them.

Under section 125 rules, an employee is classified as “highly-compensated” if they meet any of these criteria:

• They hold an officer position within the company;
• They own 5% or more of the company’s shares;
• They earn an annual salary that exceeds the limit specified in Sec. 414(q)(1)(B),which is $155,000 as of 2024.
• Fall within the top 20% of earners in the company, should the employer choose this classification as per Sec. 414(q)(3).

Key employees, along with their spouses and dependents, are identified as:

• For plan year 2024, officers receiving compensation according to Sec. 416(i)(1) amounting to $215,000 for the 2023 plan year are considered key employees.
• Individuals owning 1% of the company with annual earnings of $150,000 (not indexed) or more for the plan year; or
• Those owning 5% of the company or earned, no matter what they earned last year. 

Documentation Requirements

Section 125 sponsors must establish detailed written documentation for their plans.

Required documents include:

• A comprehensive plan document
• A summary document for employees

These documents must precisely define the fiscal period of the plan. Any alterations to this period must be justified by legitimate business reasons, such as synchronizing with the fiscal year of the healthcare provider. They cannot be arbitrary and only for the convenience of the employer.

The summary plan document must be distributed to all eligible employees within 90 days of their enrollment.

Detailed requirements for these documents can be found in Proposed Regulations Section 1.125-1(c).

Section 105 MERPs vs. Section 125 Cafeteria Plans

Both Cafeteria Plans and MERPs are tax-advantaged vehicles that allow employers to help employees access benefits and pay qualified medical expenses with tax-free dollars.

Contributions to both plans are fully tax-deductible to employers as a compensation expense, up to certain limits, in some cases.

Benefits under both plans are tax-free to workers. They are also exempt from payroll taxes as well as income taxes.

But there are important differences, as well. This section will dive into the differences between these two popular types of plans, and discuss when each of them may be most suitable for employers.

Let’s take a more detailed look at each of them, in turn:

MERPs

The term MERP stands for medical expense reimbursement plan.

These are established under Section 105 for the U.S. Tax Code. MERPs are IRS-approved plans under which employers reimburse qualified medical expenses of employees and their family members.

Types of Section 105 MERPs

• Healthcare Flexible Spending Account (FSAs). FSAs allow employees to contribute a portion of their salary on a pre-tax basis to an account that can be used to reimburse eligible medical expenses not covered by insurance, such as deductibles, copayments, and certain over-the-counter medications.
• Health Reimbursement Arrangement (HRA)s. HRAs are employer-funded accounts that reimburse employees for eligible medical expenses. Employers establish and fund HRAs, and employees can use the funds to pay for qualifying healthcare expenses, including deductibles, copayments, and certain medical premiums.
• Post-Retirement Medical Reimbursement Plans. These plans are designed to reimburse retired employees for eligible medical expenses incurred after retirement. Employers may set aside funds to cover medical costs for retired employees, providing a valuable benefit to help cover healthcare expenses during retirement.
• Retiree Health Reimbursement Arrangements (Retiree HRA)s. Similar to a post-retirement medical reimbursement plan, Retiree HRAs are employer-funded accounts that provide tax-free reimbursements for medical expenses incurred by retired employees. These arrangements help retirees manage healthcare costs during their retirement years.
• Self-Insured Medical Reimbursement Plan. Some employers choose to self-insure their health benefits and establish a self-insured medical reimbursement plan to reimburse employees for eligible medical expenses. These plans give employers more control over healthcare costs and may offer flexibility in plan design.

Types of Section 105 HRAs

Employers have five basic options for Section 105 HRA plans

• Integrated HRAs. Integrated HRAs are designed to work alongside a group health insurance plan. Employers can use them to reimburse employees for out-of-pocket medical expenses not covered by the group health plan, such as deductibles, copayments, and coinsurance.
• Qualified Small Employer HRA (QSEHRAs). QSEHRAs are available to small employers with fewer than 50 full-time equivalent employees who do not offer a group health plan. Employers can use QSEHRAs to reimburse employees for medical expenses, including health insurance premiums, up to a maximum annual limit set by the IRS.
• Excepted Benefit HRAs. Excepted Benefit HRAs are a type of HRA that provides limited reimbursements for certain medical expenses, such as dental and vision care, and premiums for COBRA continuation coverage, short-term health insurance, or other coverage that does not qualify as minimum essential coverage.
• Individual Coverage HRAs (ICHRAs). ICHRAs allow employers of any size to reimburse employees for individual health insurance premiums and other medical expenses. Unlike QSEHRAs, there are no limits on employer size or contribution amounts with ICHRAs. Employees must have individual health insurance coverage to participate in an ICHRA.
• Retiree HRAs. Retiree HRAs are used by employers to provide tax-free reimbursements for medical expenses to retired employees. These HRAs can help retired employees pay for health care expenses not covered by Medicare or other retirement benefits.

How Does a MERP Work? 

MERPs work differently from Section 105 Cafeteria plans in that Section 105 Cafeteria plans can be and usually are at least partially employee-funded. A MERP, in contrast, can only be funded by the employer. Employees cannot contribute to Section 105 Plan MERPs.

The MERP Process

When an employer sets up a MERP, they will establish a set monthly allowance per employee. The MERP will reimburse employees for out-of-pocket medical expenses up to that amount.

With a MERP, employers set a monthly allowance amount for each employee. That allowance represents the maximum amount an employer will reimburse the employee for their monthly healthcare expenses.

If an employee or covered dependent has a need, they purchase whatever healthcare services or goods they need, generally paying for them up front.

In some cases, depending on the type of MERP and the plan rules, employees can also buy ACA-qualified Marketplace coverage on the individual market.

Workers then submit proof of expenses to the plan, and the plan reimburses them.

Section 105 MERP benefits are pre-tax, and not subject to payroll taxes. This potentially saves workers thousands of dollars per year, and results in substantial savings for the employer, as well, thanks to the payroll tax exemption.

With Section 105, the emphasis is on reimbursing employees for the actual medical expenses they incur out of pocket.

Using MERPs to Customize Employee Health Plans

MERPs and health reimbursement arrangements (HRAs) are very similar in concept. However, MERPs have one key advantage over HRAs: Employers can “stack” multiple types of MERPs along with a single underlying health plan.

For example: You can offer employees a high-deductible health plan, which allows your workers to contribute to a health savings account, if desired.

Then, in addition to your basic health insurance plan, you can offer two MERP options to allow employees to customize their health plan to better meet their unique circumstance.

For example, one MERP plan may simply reimburse employees for deductibles under the HDHP, while another separate MERP may include reimbursement for additional benefits, such as dental and vision care and alternative medicine treatments such as chiropractic care.

It’s like allowing workers to choose pizza toppings:

Everyone likes different toppings. But everyone gets the same basic crust and tomato sauce.

The MERPs are the custom toppings on the “pizza” of your basic employer group health plan.

By using multiple MERPs to provide supplemental benefits over and above the base one-size-fits-all group health insurance plan, you can help employees with vastly different coverage needs customize your health benefits to suit their own exact circumstances. 

Eligible Medical Expenses in Section 105 Plans vs. Section 125 Cafeteria plans

Section 105 plans allow for a much broader array of reimbursable medical expenses compared to Section 125 cafeteria plans. 105-eligible plans include a wide range of expenses not covered under individual health insurance plans.

In contrast, only certain types of benefits in Section 125 plans qualify for pre-tax dollar treatment.

• Group health benefits
• Accident and disability coverage
• Adoption assistance
• Dependent care assistance
• Group-term life insurance coverage
• Health savings accounts (HSAs)

There are many other potential benefits for employees that may not be paid for with pre-tax dollars. These include:

• Long-term care insurance
• Employee discount programs
• Commuter benefits
• Gym memberships
• Minimal or de minimis benefits

MERPs vs. Health Reimbursement Arrangement (HRA)s

Health Reimbursement Arrangement (HRAs) and MERPs are very similar in concept: 

• Both allow employers to reimburse employees for eligible medical expenses with tax-free dollars.
• Both are solely employer-funded. Employees cannot contribute to either type of plan.

But HRAs have some restrictions that MERPs don’t.

• HRA rules don’t allow for  stacking multiple types of HRA plans to customize a single health plan.
• With HRAs, you can only have one arrangement per health plan.
• Qualified Small Employer HRAs (QSEHRAs) cannot be coupled with an employer-sponsored group health plan at all.

Table 1. Section 105 Plans Vs. Section 125 Cafeteria Plans

Feature	Section 105 Plans (MERPs, HRAs)	Section 125 “Cafeteria Plans”
Definition	A tax provision that allows employers to provide tax-free reimbursements for medical expenses to their employees. Also called medical expense reimbursement plans, health reimbursement arrangements, or HRAs.	Also known as a "Cafeteria Plans," these plans allow employees to choose from a variety of pre-tax benefit options offered by the employer.
Purpose	Primarily designed to reimburse employees for medical and health-related expenses.	Offers a broader range of benefit options compared to Section 105 plans. Employees can allocate pre-tax dollars to various benefits.
Eligibility	Typically used by small businesses and self-employed individuals to reimburse workers and eligible dependents for qualified medical expenses.	Available to employees of any participating employer. Section 125 Cafeteria plans typically include multiple benefits for employees to choose from, such as FSAs, HSAs, hospital/accident insurance, disability insurance, legal services plans, pet insurance plans, life insurance, and many others.
Tax Benefits	Reimbursements are tax-free to the employee and fully tax deductible for the employer. Employer expenditures on Section 105 benefits are not subject to payroll taxes.	Employees reduce their taxable income by electing pre-tax deductions for benefits, lowering overall tax liability. Employee contributions are pre-tax, which also reduces employer payroll tax obligations.
Types of Benefits	Focused on health-related expenses, including insurance premiums, deductibles, and other out-of-pocket costs.	Includes health insurance premiums, FSAs, HSAs, dependent care, and other elective benefits.
Funding	Funded solely by the employer. Employees cannot contribute. Salary reduction is not permitted.	Funded through employee pre-tax salary reduction, employer contributions, or a combination of both. Employers have flexibility to determine how much to contribute.
Plan Administration	Requires plan documents and adherence to non-discrimination rules, but typically simpler than Section 125 plans.	Requires a formal plan document, annual elections by employees, and adherence to specific IRS regulations.
Key Advantages	Provides a simple way for small employers to offer health benefits. Benefits are tax-free to the worker. Reimbursed expenses are not subject to FICA taxes, saving employers money.	Offers employees a tax-advantaged way to pay for a wide range of benefits, enhancing overall compensation packages. Benefits are tax-free to the worker. Employee contributions via salary reduction are not subject to FICA taxes, saving employers money.
Regulatory Compliance Considerations	Must comply with ACA, HIPAA, and other health-related regulations depending on the structure.	Must comply with IRS rules, including non-discrimination testing to ensure fairness among employees.

Table 2. Types of Health Reimbursement Arrangements (HRAs)

Feature	Qualified Small Employer HRA (QSEHRA)	Individual Coverage HRA (ICHRA)	Excepted Benefit HRA (EBHRA)
Eligibility	Available to small employers with fewer than 50 full-time employees that do not offer group health insurance.	Available to employers of any size. ICHRAs must be integrated with individual health insurance coverage.	Employers of any size can offer it alongside a traditional group health plan.
Annual Contribution Limits	There are set annual contribution limits that are adjusted for inflation. As of 2024, the QSEHRA contribution limits are $6,150 for a single employee's coverage ($512.50 per month), and $12,450 for family coverage ($1,037.50 per month).	No maximum contribution limits. Employers can set their own limits.	Limited to a smaller amount compared to other HRAs. As of 2024, the maximum allowable EBHRA benefit is $2,100. This amount is adjusted annually for inflation.
Employee Coverage	Can reimburse premiums for individual health policies and other qualified medical expenses.	Can be used to reimburse premiums for individual health insurance and other qualified medical expenses.	Reimburses other qualified medical expenses but not individual health insurance premiums.
Reimbursement Conditions	Employees must purchase an ACA-qualified health insurance policy in order to receive the benefit. Generally, the benefit is designed to reimburse the worker for premiums paid for the health insurance plan they select. Employees must provide proof of minimum essential coverage.	Employees must be enrolled in individual health insurance coverage.	Excepted benefits like dental and vision care are typically covered, not major medical expenses.
Tax Benefits	Reimbursements are tax-free to employees and tax-deductible for the employer.	Reimbursements are tax-free to employees and tax-deductible for the employer.	Reimbursements are tax-free to employees and tax-deductible for the employer.
Design Flexibility	Limited flexibility. The same terms must be offered to all eligible employees.	High flexibility. Employers can design different terms for different classes of employees.	Limited to excepted benefits; cannot be used to reimburse individual health premiums.
Regulatory Compliance	Must comply with specific QSEHRA rules set by the IRS, including notice and reporting requirements.	Must comply with ICHRA regulations, including employee notice requirements and documentation.	Must comply with EBHRA regulations and cannot be used as a standalone benefit.
Key Advantage	Enables small employers to offer a health benefit without sponsoring a group health plan.	Provides significant design flexibility and allows for personalized health coverage.	Offers an additional benefit to employees covered under a group plan for extra expenses

Section 125 Premium Only Plans

The premium only plan is the simplest form of a Section 125 plan and allows employees to pay their health insurance premiums with pre-tax dollars. This means that.

Unlike more comprehensive Section 125 plans that may include flexible spending accounts (FSAs) for health care and dependent care expenses, a premium only plan is limited to just the insurance premium deductions. It does not include options for pre-tax savings on other types of expenses, like medical out-of-pocket costs or dependent care costs.

Employers who offer a premium only plan must create a written plan document that outlines the benefits, establish the plan with the IRS, and adhere to certain non-discrimination tests to ensure the plan doesn’t favor highly compensated employees over others.

These plans only reimburse employees for insurance premiums, and not for anything else.

Eligibility

Section 125 Eligibility Criteria

Generally, most W-2 employees can participate in your Section 125 plan. However, the following categories of workers are not eligible to participate:

• Self-employed workers
• Partners (within the partnership)
• Shareholders with more than a 2% interest in an S-corporation

Section 105 Plan Eligibility Criteria

• Generally, anyone considered a statutory employee can participate in a 105 plan.
• Owners are not eligible – unless they are owner-employees of their own corporation or LLC.

Section 125 or Section 105: Which Should You Choose?

Both of these types of plans have advantages that are worth consideration for employers of all sizes.

But they have important differences in plan design, contribution structure, and in what types of expenses are qualified for the most favorable tax treatment.

The main difference between these two sections is in how these benefits are funded.

If you are planning on having the company pay for all these benefits, then Section 105 may be the way to go.

Section 105 allows employees to use your benefit for a much wider array of qualified medical expenses than Section 125 plans. And you as the employer still get the same tax benefits: Contributions to Section 105 plans are fully deductible to the employer, and not taxable to the employee.

This is much more tax efficient than trying to provide an equivalent value in direct cash or other taxable compensation.

The drawback to Section 105 plans is that they must be 100% employer-funded. Employees don’t get to contribute to Section 105 plans.

That’s where Section 125 Cafeteria plans have some important advantages:

Unlike Section 105 plans, Section 125 plans let employees contribute to the costs of running these plans via pre-tax payroll deductions.

This reduces taxes for the employee, reduces payroll taxes for employers, and helps provide the maximum “bang for the buck” when it comes to offering employee benefits.

Section 125 plans are extremely flexible: It’s easy for employees to pick and choose which benefits suit their lifestyle and circumstances best. So there are no worries about imposing a “one-size-fits-all” package on a diverse workforce.

And because they are employee funded rather than funded out of company coffers, Section 125 plans allow you to provide these valuable benefits at little to no cost to the employer.

How To Start a Section 125 cafeteria plan

Here’s a step-by-step guide to help you get started offering a Section 125 cafeteria plan.

• Choose a plan administrator. You will need to choose a plan administrator to manage your cafeteria plan. You can have someone do this in house, but the vast majority of small businesses outsource this function to a third-party benefits administrator.
• Determine which benefits to offer. You will need to decide which benefits to offer in your cafeteria plan. Consider surveying your employees to find out which benefits are most important to them.
• Set up your plan documents. Your plan document outlines the terms and conditions of your cafeteria plan. It should include information on the benefits offered, eligibility requirements, enrollment procedures, and contribution limits. You can work with your plan administrator or consult with a benefits consultant or attorney to help you draft your plan documents.
• Communicate the plan to your employees. Once your plan is in place, you will need to communicate it to your employees. Provide them with information on the benefits offered, enrollment deadlines, and contribution limits. You can also offer educational materials or hold informational sessions to help your employees understand how the plan works and how they can maximize their benefits.
• Monitor and administer the plan. Once your cafeteria plan is up and running, you will need to monitor and administer it on an ongoing basis. This includes processing employee contributions, coordinating with your plan administrator, and ensuring that your plan remains compliant with IRS regulations.

What documents do you need to start a Cafeteria plan?

To start a cafeteria plan, you will need to have several documents in place. Here are some of the most important documents you will need:

• Plan document. A plan document is a legal document that outlines the terms and conditions of your cafeteria plan. It should include information on the benefits offered, eligibility requirements, enrollment procedures, contribution limits, and other important details. Your plan document should also comply with IRS regulations and other applicable laws.
• Summary plan description (SPD). An SPD is a document that summarizes the key features of your cafeteria plan in plain language. It should be written in a way that is easy for employees to understand and should include information on the benefits offered, enrollment procedures, contribution limits, and other important details.
• Enrollment forms. You will need to provide employees with enrollment forms that they can use to elect the benefits they want to participate in. Your enrollment forms should include clear instructions on how to enroll and should collect all the necessary information from employees, such as their name, address, social security number, and benefit elections.
• Employee communications. You should provide employees with clear and concise communications about your cafeteria plan, including information on the benefits offered, eligibility requirements, enrollment procedures, and contribution limits. You may also want to provide educational materials or hold informational sessions to help your employees understand how the plan works and how they can maximize their benefits.
• Plan administration agreements. If you are using a third-party administrator to manage your cafeteria plan, you will need to have a plan administration agreement in place. This agreement should outline the roles and responsibilities of both parties and should include information on fees, services, and other important details.
• IRS forms. You will need to file various IRS forms to establish and maintain your cafeteria plan, including Form 5500, Form 5500-SF, Form 5500-EZ, and Form 1095-C. You may also need to file additional forms depending on the type of plan you offer and other factors.

Note: The documents required to start a cafeteria plan may vary depending on the type of plan you offer and other factors. Employers should consult with a benefits consultant or tax professional to ensure that they have all the necessary documents in place to establish and maintain their cafeteria plan.

If you already use a major payroll vendor, such as ADP, they can help you with the requirements to start a cafeteria plan for your small business.

Conclusion

Section 125 cafeteria plans can be a great way for small business owners to offer competitive employee benefits while also saving money on taxes.

By following these steps, you can set up a cafeteria plan that meets the needs of your employees and helps you attract and retain top talent.

As always, it is important to consult with a tax professional or benefits consultant to ensure that you meet all the necessary requirements and regulations.

Here are some additional articles for further reading: Healthsharing for Small Businesses: What Business Owners Need to Know | Employers: What To Do If Your Humana Group Plan Cancels | The Small Business Health Care Tax Credit: Who Can Get It, How To Claim It

Here are some additional pages related to this article: Healthshare Plans | HSA Insurance Plans | Health Insurance for Small Business Owners

Frequently Asked Questions about Section 125 Cafeteria Plans and HSAs

What is a Health Savings Account (HSA), and why should my business consider offering it?

A Health Savings Account is a tax-advantaged savings account that employees can use to save for qualified medical expenses. Offering HSAs can help attract and retain employees by providing a valuable benefit and potentially reducing their tax burden.

Can small businesses offer HSAs to their employees?

Yes, small businesses can offer HSAs as part of their employee benefits package, regardless of their size. However, there may be certain eligibility requirements and contribution limits to consider.

What is a Section 125 “cafeteria” plan, and how can it be used with HSAs?

Section 125 cafeteria plan is an IRS-approved arrangement that allows employees to pay for certain benefits on a pre-tax basis. It can be used to offer HSAs alongside other eligible benefits, such as health insurance premiums.

What are the advantages of using a Section 125 plan to offer HSAs?

By utilizing a Section 125 plan, employees can contribute to their HSAs with pre-tax dollars, reducing their taxable income and potentially saving on payroll taxes for both the employer and employee.

Are there contribution limits for HSAs under a Section 125 plan?

Yes, there are annual contribution limits set by the IRS. For 2024, the limit for individuals is $4,150, and for family coverage, it’s $8,300. Additional “catch-up” contributions of $1,000 per person are allowed for employees aged 55 or older.

Can employees use HSA funds for non-medical expenses?

HSA funds used for non-medical expenses are subject to income tax and an additional 20% penalty. However, after age 65, HSA funds can be withdrawn for any purpose without the additional penalty (though income tax may still apply).

Can employees use their HSA funds to pay health insurance premiums?

The general rule is that HSA funds cannot be used to pay health insurance premiums, though there are exceptions. For example, taxpayers can use HSA funds to pay health insurance premiums while collecting federal or state unemployment, or to pay COBRA continuation coverage premiums.

If a taxpayer uses HSA dollars to pay for other medical insurance premiums other than COBRA or while collecting unemployment benefits, the withdrawal will be deemed a non-qualified medical expense. Any such withdrawals would be subject to income tax and a 20% penalty if the individual is younger than age 65 and not disabled.

Can employees use HSA funds to pay long term care insurance premiums?

Yes, subject to certain limitations that vary by age.

Are there any reporting or disclosure requirements for employers offering HSAs?

Employers offering HSAs may have reporting requirements, such as providing Form W-2 with HSA contributions and reporting HSA contributions on Form 5500 for larger plans. It’s important to stay compliant with IRS regulations.

Can employees carry over their HSA funds from year to year?

Yes, unlike Flexible Spending Accounts (FSAs), health savings accounts don’t have “use it or lose it” provisions. HSA funds can be carried over from year to year, and compound tax-deferred as long as the money remains in the HSA. Employees can accumulate and invest their HSA funds, building a long-term savings account for future healthcare expenses.

What happens to an employee’s HSA if they leave the company?

HSAs are individually owned, meaning the account stays with the employee even if they change jobs or leave the company. They can continue using the funds for eligible expenses or save for future medical costs.

Can employees contribute to an HSA if they have other healthcare coverage?

Generally, employees can contribute to an HSA as long as they have an HDHP and meet the other eligibility requirements. However, additional healthcare coverage like non-HDHP plans, Medicare, or access to TRICARE or VA health care may disqualify individuals from being able to make pre-tax HSA contributions.

However, those individuals can still use their HSA dollars for qualified medical expenses tax-and-penalty free.

Are there penalties for non-qualified HSA withdrawals?

Yes, non-qualified HSA withdrawals may be subject to income tax and an additional 20% penalty, up until age 65. After age 65, withdrawals for anything other than qualified medical expenses remain subject to ordinary income tax, similar to a traditional IRA. However, the 20% penalty goes away.  Health Savings Accounts can be a very useful tool for supplementing retirement income.

However, it’s crucial for employees to understand the rules surrounding what constitutes a qualified medical expense to avoid any penalties. Full information about qualified medical expenses can be found in IRS Publication 502 – Medical and Dental Expenses.

Should I consult with a benefits broker or professional to help set up an HSA and Section 125 plan?

Yes, working with a benefits broker or professional is highly recommended. They can guide you through the setup process, provide expertise on plan design and compliance, and ensure you maximize the benefits of HSAs and Section 125 plans.

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