Paying for Individual Health Insurance Through Tax-Sheltered Cafeteria Plans

Only employees who purchase individual insurance outside their workplaces must use after-tax dollars. It is legally ambiguous whether employers may offer benefits on a pre-tax basis through Section 125 “cafeteria plans” without violating previous health reform laws. State and federal law on the taxation of employees’ premiums for individual health insurance are unclear as to cafeteria plans’ legality, and implementation of health reform in 2014 will only partially resolve the confusion.

The authors interviewed regulators, insurers, agents, employer groups and benefits advisors and administrators in three states, and examined relevant legal rulings, marketing materials and other documents.

Key Findings:

  • It is unclear whether the state-level practice of purchasing individual insurance through a combination of tax-sheltered payroll deductions and cafeteria plans circumvents insurance reform laws.
  • Federal law is complex and fragmented: legal interpretation of Section 125 plans is different under the Employer Retirement Income Security Act than under the Internal Revenue Code.

Implementation of the Patient Protection and Affordable Care Act of 2010 (PPACA) in 2014 will only partially resolve the legal uncertainty. It will be illegal to use cafeteria plans to pay for individual insurance in insurance exchanges; it is unclear if cafeteria plans will be legal outside exchanges. The authors recommend that Congress eliminate the need for Section 125 plans by eliminating the tax differential between employer- and individual-purchased insurance.