Biz Tips: The legal ins and outs of a Section 125 plan
All businesses must have one by July 1
By ROSALIE A. BEITH
The new Massachusetts Health Care Reform Law, which takes effect July 1, significantly changes the landscape of health insurance in Massachusetts. The law is designed to increase access to health insurance both for individuals and for employers by: providing subsidies to the low-income uninsured, requiring individuals 18 and older to have health insurance, requiring employers with 11 or more full-time employees to either offer health insurance or make a Fair Share Contribution and reforming the small and non-group health insurance markets.
In addition, employers of more than 10 employees, regardless of whether they offer health insurance, must adopt a Section 125 plan that meets the regulations of the Commonwealth Connector, the state agency charged with administering the Health Care Reform Law. Failure to offer a Section 125 plan will subject an employer to the Free Rider Surcharge for state-funded health services incurred by the employer’s employees and their dependents.
Fed regs
Although the material issued by the Commonwealth Connector emphasizes that an employer’s Section 125 plan must comply with Massachusetts regulations, a Section 125 plan is subject to extensive regulation under federal law. A Section 125 plan, also known as a cafeteria plan, derives its name from Internal Revenue Code Section 125, which governs the plan’s terms and administration.
Under a Section 125 plan, an employee is given the opportunity to elect a reduced salary in return for certain types of "qualified" benefits. For example, an employee may file an election to reduce his or her salary by the amount of $100 per month, and that $100, unreduced for taxes, will be applied by the employer to the cost of a qualified benefit. The net effect is that the employee is funding the benefit with pre-tax dollars.
While health insurance is one of the qualified benefits that can be funded through a Section 125 plan, dental, disability or group life insurance can be offered, as well.
A Section 125 plan also can be used to fund flexible spending accounts that allow the payment of out-of-pocket medical and dependent care expenses. The requirements of the Commonwealth Connector, however, are limited to the payment of health insurance premiums through the Section 125 plan.
In addition to making benefits more affordable, the use of a Section 125 plan can lower taxable income for employees, thereby generating tax savings. These advantages come at a price, however, since operating a Section 125 poses some administrative challenges. As an initial matter, appropriate recordkeeping and tax reporting mechanisms must be put in place. In addition, elections can only be made prospectively and cannot apply retroactively.
More significantly, an election under a Section 125 plan is generally irrevocable for the plan year. The participant who elected a reduction of income in the amount of $100 per month cannot decide later in the year that he or she would rather have the cash. In the same vein, an employee who chooses not to participate in the Section 125 plan cannot elect participation in the middle of the plan year.
An employee can only elect to participate in the Section 125 plan during the designated annual open enrollment period, within a specified time of initial hire or within a specified time of initial eligibility for the plan.
Change in status
The IRS regulations do allow a change in the salary reduction election under certain specified circumstances, referred to as "change in status" situations. A plan is permitted to allow these changes in election but is not required to do so, and the IRS rules are complex and detailed.
In addition, special mid-year enrollment rights are provided under HIPAA. As an example, a plan may allow participants to change elections in the event the participant has a change in marital status or has a child.
The change in the election, however, must always be consistent with the change in status. If a participant has a child, the participant may be allowed to elect dependent health coverage, but the participant may not elect disability coverage until the next open enrollment.
As is evident, a Section 125 plan involves more than simply executing a plan document, and it makes sense for all employers to understand the implications of a Section 125 plan when analyzing options under the Massachusetts Health Care Reform law.
Further, if the employer concludes that establishing a Section 125 plan is the appropriate course of action, the employer can expand the plan to provide for the pre-tax funding of other benefits in addition to health insurance.
Rosalie A. Beith is of counsel
at the Worcester-based law firm
of Fletcher, Tilton & Whipple. She can be reached at rbeith@ftwlaw.com.
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