How an HSA works with a Section 125 Cafeteria Plan

Some of you might have heard of a “Cafeteria Plan.” A smaller number may have even heard the term “Section 125,” the section of the IRS code governing the rules. However, most HSA owners have never really needed to know these terms, much less understand the underlying mechanics governing the employer benefits programs it created. Still, for a minority, including those serving in a company benefits role or as a benefits consultant, you may have a stronger interest in how the Section 125 plan interacts with an HSA. Here we will explain.

First, some background. A Cafeteria Plan is a written plan sponsored by an employer whereby “participants may choose among two or more benefits consisting of cash and qualified benefits,” hence the term “cafeteria” in describing the options available to employees. Importantly, the value of these options are excluded from an employee’s gross income and therefore not taxable to the individual, one of the reasons for their popularity.

While employers face certain restrictions to make sure the economic benefits of these plans do not discriminate in favor of highly compensated employees or key employees, that has not limited their rise in popularity. One of the more notable restrictions is on their use in deferred compensation arrangements. Essentially employers are prohibited from using Section 125 plans to defer compensation, though even here there are a few notable exceptions, including HSAs.

What does this mean?

A (thankfully) brief analysis of potential tax savings from a Section 125, Cafeteria Plan benefit.

Well, recall that for both Section 125 benefits and Health Savings Accounts there are significant tax savings available. Not only are qualified benefits meeting program requirements exempt from gross income, and therefore income tax, they are also excluded from payroll tax by your employer. Payroll tax is another 15.3%, split evenly between the employer and employee at 7.65%. Generally speaking the most popular way employers achieve this goal is through program administration in a Section 125 plan.

So while not the only way for an employer to make contributions into an individual’s HSA — money that is then owned by the employee and cannot be retrieved by the employer — the Section 125 plan is the most common as these plans are well established, providing an existing set of rules an HR department can plug the HSA contributions into (both employer and employee, if elected).

As with most topics tax and qualified benefits-related, there are more rules and details, including even other HSA funding options. However, for most HSA owners a Section 125 plan is not only compatible with an HSA, it is likely the mechanism “behind the scenes” enabling your contributions to remain pre-payroll tax, a nice little benefit indeed.

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About Aaron Benway, CFP, EA — Aaron is a Certified Financial Planner (CFP)and IRS Enrolled Agent (EA). He co-founded HSA Coach, a digital tool to educate consumers on HSAs, track health expenses and other documents, and provide individual financial calculators, to help consumers get the most from their HSA and other savings. To help individuals directly with their financial planning and wealth management requirements he founded AB Financial Planning.

Prior to HSA Coach Aaron was the CFO of HelloWallet, a financial wellness software startup purchased by investment research firm Morningstar. Earlier in his career Aaron was an investor at The Carlyle Group and a nuclear engineer in the US Navy. Aaron has an Electrical Engineering degree from the US Naval Academy and an MBA from Harvard Business School. Aaron lives in the Washington DC area with his wife and two children.