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Purchasing Minnesota Health Insurance with Section 125 Plans

Using Section 125 Plans to Purchase Health Insurance

What is a Section 125 plan?

The term "Section 125 plan" refers to section 125 of the United States Internal Revenue Code; Section 125 plans are also referred to as "cafeteria plans." This section of the tax code establishes rules for employers that offer employees a choice between taxable and nontaxable benefits (including, but not limited to, health insurance coverage). As envisioned in Governor Pawlenty's 2007 "Healthy Connections" proposal, employers with more than 10 employees would have been required to establish a "premium only" plan that would have allowed employees to choose to have part of their salary withheld to purchase health insurance coverage in the individual market. Employers could choose to establish Section 125 plans that offer other nontaxable benefits as well, but would not be required to do so. Under a Section 125 plan, employers are not required to contribute to the cost of health insurance.

Impact on Employers

For employers, there are financial benefits to establishing a Section 125 plan. For example, employers do not pay Medicare, Social Security, or unemployment insurance taxes on the amounts that employees choose to have withheld from their paychecks on a pre-tax basis. It is inexpensive for an employer to set up a Section 125 plan, and so if even only a few employees choose to take advantage of the ability to buy health insurance with pre-tax dollars, the employer can realize a net financial gain.

Impact on Individuals

Individuals who buy health insurance through a Section 125 plan benefit from the ability to pay for coverage with pre-tax earnings. Depending on their income, the amount of money that individuals can save by paying for health insurance this way is about 30 to 50% of the cost of health insurance. Because of interactions with other parts of the tax code (particularly the Earned Income Tax Credit), the estimated savings are highest for people with relatively low incomes.

When individuals choose to reduce their taxable salary and receive pre-tax benefits instead, there can be an impact on their future Social Security benefits. Although the size of the impact varies depending on individual circumstances, the reduction in future Social Security benefits was small - ranging from about $4 per month to $26 per month - in examples provided to the Legislature in 2007 by the Minnesota Department of Revenue.

Impact on State Revenues

When individuals reduce their taxable income by shifting part of their compensation from after-tax to pre-tax benefits, both the state and federal governments experience a loss of tax revenue. Because federal income tax rates are much higher than the state's rates, about 80% of the revenue impact would be on the federal government. In other words, for every dollar of revenue that the state would lose, the federal government would lose $4; this compares very favorably to the current 50/50 split between the state and federal government for the Medicaid program.