Introduction

This guide provides an overview of the most relevant tax considerations for employee health and welfare benefit plans. This guide does not address the tax considerations applicable to retirement plans, nor does it include all of a plan sponsor’s/employer’s tax considerations under all applicable federal, state, or local tax laws. It is important to remember that many of the issues addressed in this guide involve complex tax and legal considerations. As a result, employers and individuals must work with their tax advisors and legal counsel when making decisions regarding these issues.

Section 125 General Rules¹

Section 125 of the Internal Revenue Code governs cafeteria plans and allows employees to make pre-tax salary reduction contributions for health and welfare benefits elected under a cafeteria plan.

Plan Document

To enable employees to make pre-tax salary reduction contributions for health and welfare benefits, an employer must establish a Section 125 plan (cafeteria plan). The terms of a cafeteria plan must be set forth in a written plan document. Technically, if an employer does not have a written cafeteria plan document, employees may not pay for health and welfare benefits on a pre-tax basis. Employees who contribute pre-tax dollars towards benefits that would otherwise be eligible for pre-tax payment could be responsible for the payment of applicable taxes to the IRS for those benefits if a written cafeteria plan document has not been adopted.

Election Changes²

Participants must make irrevocable elections prior to the first day of the plan year, and any permitted mid-year election changes made under a cafeteria plan must be effective on a prospective basis (except under limited circumstances). In other words, coverage should be effective after an employee requests a change to their election. There are limited exceptions to this “prospective election” rule.

Exceptions to the Prospective Election Rule

The first exception to the “prospective election” rule applies in the case of birth or adoption of a dependent (a HIPAA special enrollment event). In this scenario, coverage changes made to a medical plan are required to be retroactively effective (back to the date of the birth/ adoption of the dependent). In addition, the employee can pay for that retroactive coverage on a pre-tax basis. However, even for the birth or adoption of a dependent, payment for retroactive coverage must come from income not currently available at the time of the election change.

The other exception to the “prospective election” rule that allows an employee to make a retroactive election is reserved for new employees. A new employee may have their coverage retroactively effective, back to the date of hire, if there is no eligibility waiting period and the employee’s new election is made within their first 30 days of employment.

¹ The rules described in this document are found in the Section 125 regulations and IRS Notice 2014-55.

² This guide provides an overview of certain cafeteria plan election change issues. For additional information see the Summary of Status Change Events (and Corresponding Permitted Election Changes)

Regulatory and Legislative Strategy Group