What Are Section 125 Plans and How Can They Be Used To Expand Health Coverage?

What Are Section 125 Plans and How Can They Be Used To Expand Health Coverage?

Lynn QuincyMathematica Policy Research

February 7, 2008

Lynn QuincyMathematica Policy Research

February 7, 2008

What Are Section 125 Plans?What Are Section 125 Plans?

IRS Code Section 125 allows workers to lower their taxable income by the amount of premiums paid for health insurance (and other qualified benefits).

Also known as:– Cafeteria Plans– Premium Only Plans (POP)  

IRS Code Section 125 allows workers to lower their taxable income by the amount of premiums paid for health insurance (and other qualified benefits).

Also known as:– Cafeteria Plans– Premium Only Plans (POP)  

Tax Treatment of Employer-Sponsored Health CoverageTax Treatment of Employer-Sponsored Health Coverage

Employer Sponsored Health Insurance Premium

($8,045)

Employer paid portion ($6,185)

Employee paid portion ($1,860)

Not Taxable Compensation to Employee

(I.R.S Code Section 105,106)

May Not Be Taxable Compensation to Employee

(I.R.S Code Section 125)

Who is Eligible? Who is Eligible?

Any employer may sponsor a Section 125 Plan.

Only employees may participate in a Section 125 Plan.

Special Case: Partners, self-employed people, and people who are more than 2% shareholders in an “S” corporation are not employees and may not participate in a Section 125 Plan (but they may sponsor such plans).

Any employer may sponsor a Section 125 Plan.

Only employees may participate in a Section 125 Plan.

Special Case: Partners, self-employed people, and people who are more than 2% shareholders in an “S” corporation are not employees and may not participate in a Section 125 Plan (but they may sponsor such plans).

The Potential Savings Depends on One’s Implicit Marginal Income Tax Rate

The Potential Savings Depends on One’s Implicit Marginal Income Tax Rate

For Lower Income Families:

Overall Marginal Tax Rates can exceed 50% at incomes below 300% FPL.

Marginal Tax Rates vary tremendously by income and family type.

Marginal Tax Rates can be negative for families with children at incomes below 125% FPL.

For Lower Income Families:

Overall Marginal Tax Rates can exceed 50% at incomes below 300% FPL.

Marginal Tax Rates vary tremendously by income and family type.

Marginal Tax Rates can be negative for families with children at incomes below 125% FPL.

Federal Tax Bracket Rates

Federal Tax Bracket Rates

Illustration for a single parent with one child:

-20%

-10%

0%

10%

20%

30%

$9,000 $14,000 $19,000 $24,000 $29,000 $34,000 $39,000

Family Income

Federal Income Tax Bracket Rates

Federal Tax Bracket Rates vs. Implicit Marginal Income Tax Rates

Federal Tax Bracket Rates vs. Implicit Marginal Income Tax Rates

Illustration for a single parent with one child

-20%

-10%

0%

10%

20%

30%

$9,000 $14,000 $19,000 $24,000 $29,000 $34,000 $39,000

Family Income

Federal Income Tax Bracket Rates

Implicit Federal Marginal Income Tax Rates

Tax Code Features Designed to Assist Lower Income Taxpayers …

Tax Code Features Designed to Assist Lower Income Taxpayers …

– Earned Income Tax Credit – slides with income and fully refundable

– Child Tax Credit – partially refundable

– Dependent Care Tax Credit – not refundable but credit percentage higher at lower incomes

… cause implicit marginal income tax rates to diverge from federal income tax bracket rates

– Earned Income Tax Credit – slides with income and fully refundable

– Child Tax Credit – partially refundable

– Dependent Care Tax Credit – not refundable but credit percentage higher at lower incomes

… cause implicit marginal income tax rates to diverge from federal income tax bracket rates

The Value of the EITC by Family Type (2005)The Value of the EITC by Family Type (2005)

$0$500

$1,000$1,500$2,000$2,500$3,000$3,500$4,000$4,500$5,000

$0 $5,000 $10,000 $15,000 $20,000 $25,000 $30,000 $35,000 $40,000

Family Earnings

EIT

C A

mo

un

t Tw o or more Children

One ChildChildless

--- Married filers are allowed higher maximum earnings than unmarried filers.

Potential Marginal Tax Rates Facing a Single Parent with Two Children*

(Negative rates not displayed)

Potential Marginal Tax Rates Facing a Single Parent with Two Children*

(Negative rates not displayed)

0%

10%

20%

30%

40%

50%

60%

$9,398 $11,862 $13,687 $17,337 $20,986 $24,636 $29,198 $34,673 $40,148 $45,623 $51,097

Family Income

Ta

x S

ub

sid

y P

erc

en

tag

e

State

FICA

Federal

* Assumes the state levies an income tax and has a state EITC (most advantageous scenario)

Warning:

May want to locate binoculars.

Overall Marginal Income Tax Rates Vary by Family Composition*

Overall Marginal Income Tax Rates Vary by Family Composition*

Shaded areas indicate overall marginal tax rates in excess of 40 percent.

Income as a Percent of FPL

75% 100% 125% 150% 175% 200% 225% 250% 275% 300%

Family Composition: Adults Kids

1 0 32% 35% 37% 32% 30% 30% 30% 40% 40% 40%2 0 15% 22% 16% 24% 30% 26% 25% 27% 30% 30%

1 1 1% 4% 18% 46% 48% 47% 46% 41% 31% 31%1 2 -15% 21% 28% 55% 50% 53% 45% 31% 31% 31%

2 1 1% 4% 0% 26% 45% 42% 40% 41% 30% 30%2 2 -35% -8% 1% 23% 26% 45% 47% 48% 48% 40%2 3 -47% -11% 1% 28% 31% 31% 31% 54% 54% 42%

* Assumes the state levies an income tax and has a state EITC (most advantageous scenario)

Employers Also Benefit from Section 125 Plans

Employers Also Benefit from Section 125 Plans

When payroll is lower by the amount of the employee share of health premiums, the employer pays less in FICA taxes.  

When payroll is lower by the amount of the employee share of health premiums, the employer pays less in FICA taxes.  

How Can Section 125 Plans Be Used To Expand Health Coverage?

How Can Section 125 Plans Be Used To Expand Health Coverage?

Section 125 “awareness” campaign

Link Section 125 plan use to coverage expansions targeting small employers (Pac Advantage in CA)

Require employers to offer such plans (Massachusetts; Rhode Island)

Section 125 “awareness” campaign

Link Section 125 plan use to coverage expansions targeting small employers (Pac Advantage in CA)

Require employers to offer such plans (Massachusetts; Rhode Island)

What Are States Doing Now?What Are States Doing Now?

MA requires all employers with 10+ workers for pre-tax purchase of health insurance (part of a comprehensive package of health reforms).

RI enacted a "cafeteria plan" requirement for all employers with 25+ workers for pre-tax purchase of health insurance starting 2009. No state or employer payment required.

MA requires all employers with 10+ workers for pre-tax purchase of health insurance (part of a comprehensive package of health reforms).

RI enacted a "cafeteria plan" requirement for all employers with 25+ workers for pre-tax purchase of health insurance starting 2009. No state or employer payment required.

To Realize a Benefit From Section 125, the Following Must Be True

To Realize a Benefit From Section 125, the Following Must Be True

Connection to an Employer Currently unable to purchase health

insurance on a pre-tax basis Face a non-zero premium contribution Face a Federal or State Tax liability that

could be decreased (or a refund that could be increased)

Tax Savings are non-trivial Special Case: those eligible for an EITC

refund must be able to “front” the premium amounts until taxes are filed.

Connection to an Employer Currently unable to purchase health

insurance on a pre-tax basis Face a non-zero premium contribution Face a Federal or State Tax liability that

could be decreased (or a refund that could be increased)

Tax Savings are non-trivial Special Case: those eligible for an EITC

refund must be able to “front” the premium amounts until taxes are filed.

Prevalence of Section-125 Plans Among Small Employers

Prevalence of Section-125 Plans Among Small Employers

Employees in Firms of

10-24 workers

Employees in Firms of

25-99 workers

All Employees (TN) 185,187 289,304

Employees in Firms that Offer Health Ins (TN)

55,343 153,072

Percent without a Section 125 Plan (National)

50% 30%

Percent Facing Zero Health Ins Contribution (TN)

30% 42%

Source: TN MEPS-IC Data for 2005; National MEPS-IC Data for 2004

Promoting the Use of Section 125 Plans: Little Downside …

Promoting the Use of Section 125 Plans: Little Downside …

• No new legislation is required

• Requires little action on the part of employees to realize the savings

• Strengthens employer-based coverage

• Employee participation is always voluntary

• Little or no cost to employers; may be offset by FICA savings

• State may incur a tax expenditure but likely to receive a net transfer from Feds

• No new legislation is required

• Requires little action on the part of employees to realize the savings

• Strengthens employer-based coverage

• Employee participation is always voluntary

• Little or no cost to employers; may be offset by FICA savings

• State may incur a tax expenditure but likely to receive a net transfer from Feds

Promoting the Use of Section 125 Plans: … But Impact May Be Small

Promoting the Use of Section 125 Plans: … But Impact May Be Small

By itself, such a policy will have only a small impact on new coverage for workers and their families:

– Workers with the highest marginal tax rates are a small portion of uninsured workers

– No benefit for the 20 percent of the uninsured with no connection to the workforce.

May help the currently insured maintain their employer coverage

By itself, such a policy will have only a small impact on new coverage for workers and their families:

– Workers with the highest marginal tax rates are a small portion of uninsured workers

– No benefit for the 20 percent of the uninsured with no connection to the workforce.

May help the currently insured maintain their employer coverage

Contact InformationContact Information

Lynn QuincyMathematica Policy Research, Inc.Lquincy@mathematica-mpr.com

202-264-3449

Lynn QuincyMathematica Policy Research, Inc.Lquincy@mathematica-mpr.com

202-264-3449