Why Section 105 Plans are Better Than Section 125 Plans (Post-2014)

Written by: Christina Merhar
Originally published on August 29, 2013. Last updated July 8, 2015.

As businesses plan their health benefits strategy for 2014 and beyond, many are looking at ways to incorporate the advantages (and cost savings) of the individual health insurance exchanges and the individual health insurance tax subsidies

Section 105 or Section 125

Because of these advantages (guaranteed-issue coverage for all employees, and discounts on individual premiums for those eligible), most small businesses are considering a "pure" defined contribution approach.

With "pure" defined contribution, the business gives employees a set health care allowance and reimburses them for health insurance premiums and other medical expenses -- instead of offering a group health insurance plan.

Naturally, the next question is how to do this in a tax free and compliant way... the answer is to use a 100% employer-funded Section 105 medical reimbursement plan, not a Section 125 cafeteria plan.

This article examines why it's better to use a Section 105 plan post-2014.

Overview of Section 105 Plans

IRC Section 105 is the foundation of employer sponsored “medical reimbursement plans“. A Section 105 medical reimbursement plan allows businesses to reimburse an employee for medical and insurance expenses incurred by the employee or his or her dependents. 

As explained further below, employees can use employer-funded Section 105 plans to reimburse the nonsubsidized premium of their individually purchased, exchange-based plan.

Overview of Section 125 Plans

A Section 125 plan, commonly referred to as a "cafeteria plan", is a benefit provided by an employer which allows an employee a choice between taxable salary and a non taxable benefit. Common Section 125 plans are Premium Only Plans, Premium Reimbursement Accounts, and Flexible Spending Accounts (FSAs).

As explained further below, the Affordable Care Act (ACA) does not allow employees to use a Section 125 cafeteria plan to pre-tax an individually purchased, exchange-based plan.

ACA Guidelines for Section 105, Section 125, and Exchange Plans

According to the Affordable Care Act (ACA) regulations:

(1) Government-subsidized portion of medical premiums (if applicable) is not tax deductible

See PPACA Section 1401 adding Section 36(B)(g) to Subpart C of part IV of subchapter A of chapter 1 of the Internal Revenue Code of 1986:

"(g) Credit for Health Insurance Premiums- No deduction shall be allowed for the portion of the premiums paid by the taxpayer for coverage of 1 or more individuals under a qualified health plan which is equal to the amount of the credit determined for the taxable year under section 36B(a) with respect to such premiums")

(2) Unsubsidized portion of medical premiums are tax deductible. However, plans in AHBE exchanges are not qualified benefit under Section 125

See PPACA Section 1515 "OFFERING OF EXCHANGE-PARTICIPATING QUALIFIED HEALTH PLANS THROUGH CAFETERIA PLANS." This section specifies that exchange plans will not be a qualified benefit under Section 125.

(3) The Section 125 exclusion does not apply to:

1. Section 105 premium reimbursements for unsubsidized portion
2. HSA (e.g. when unemployed) premium reimbursements for unsubsidized portion
3. 1040 Schedule A deduction for premium expenses over 10% of income

Why Employer Funded Section 105 Plans Are Better in 2014

Because employer-funded Section 105 medical reimbursement plans are allowed to reimburse for employees' individually purchased, exchange-based health insurance plans (and Section 125 plans are not), it's a no-brainer to use them as the base of a defined contribution health plan in 2014 and beyond.

Do you agree or disagree? Leave a comment below.

The Comprehensive Guide to the Small Business HRA

Photo credit: Flickr, oysh9

Originally published on August 29, 2013. Last updated July 8, 2015.


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