Section 125 Cafeteria Plans and ICHRA: How Pre-Tax Premium Payments Work

How employers can coordinate CHOICE Arrangement (ICHRA) allowances with pre-tax employee premium payments, and why the enrollment channel matters.

When employers introduce a CHOICE Arrangement — the term CMS now uses for an Individual Coverage Health Reimbursement Arrangement (ICHRA) — much of the initial planning focuses on how much the company will contribute toward employee health insurance.

But employer contributions are only part of the equation. Employees may choose individual health insurance policies with premiums that exceed their monthly allowance, leaving them responsible for the difference.

Can employees pay that remaining premium with pre-tax dollars?

In certain circumstances, Section 125 of the Internal Revenue Code allows employers to offer that option through a cafeteria plan. The answer depends on where employees purchase their individual coverage, how the employer structures its benefits, and whether the necessary payroll arrangements are in place.

For employees considering Marketplace coverage, another factor enters the picture: the potential availability of premium tax credits. Understanding these choices before enrollment can make a meaningful difference in how employees evaluate their options.

What Is a Section 125 Cafeteria Plan?

A Section 125 cafeteria plan is a written employer-sponsored plan that allows eligible employees to choose between taxable compensation and certain qualified benefits.

One common application is a premium-only plan, which lets employees pay eligible health insurance premiums through pre-tax payroll deductions.

When qualifying premiums are paid through a properly established cafeteria plan, employee salary reductions generally lower wages subject to federal income tax and, under the relevant rules, Social Security and Medicare taxes. Employers may also benefit from reduced payroll tax costs.

The actual savings vary depending on the employee's circumstances and the taxes involved. There is no single savings percentage that applies to every employee.

Section 125 plans have long been used alongside traditional group health insurance. They can also play a role in an ICHRA strategy, provided the employer follows the rules governing individual health insurance premiums.

How Section 125 Works Alongside an ICHRA

An ICHRA allows an employer to establish a defined allowance toward eligible individual health insurance premiums and, depending on plan design, certain other medical expenses.

Section 125 addresses a different question: how an employee may pay the portion of an eligible premium that remains after the employer's allowance.

Consider an employer offering a $450 monthly ICHRA allowance. An employee selects individual health insurance with a monthly premium of $600.

The ICHRA can cover $450 of the eligible premium, subject to the arrangement's terms and reimbursement requirements. The employee is responsible for the remaining $150.

If that employee purchases eligible off-Exchange coverage and the employer maintains a qualifying Section 125 cafeteria plan, the $150 may be paid through pre-tax payroll deductions. Without that arrangement, the employee would generally pay the difference using after-tax funds.

Off-Exchange vs. Marketplace: Why the Enrollment Channel Matters

Where an employee purchases individual coverage determines whether Section 125 premium deductions can be used.

Off-Exchange Individual Health Insurance

Employees who purchase eligible individual health insurance directly from an insurer or through a supported off-Exchange enrollment channel may be able to pay their remaining premiums pre-tax through a qualifying employer cafeteria plan.

The employer needs appropriate Section 125 documentation, election procedures, and payroll administration. Simply offering an ICHRA does not automatically create the pre-tax deduction option.

For employees who accept their ICHRA allowance, qualifying off-Exchange coverage can provide a combination of employer premium support and potential pre-tax treatment of their remaining premium responsibility.

However, coverage purchased off-Exchange is not eligible for Marketplace premium tax credits.

That distinction matters when employees compare their available health insurance options.

Marketplace Individual Health Insurance

Employees may also purchase qualifying individual health insurance through HealthCare.gov or a state-based Marketplace.

An ICHRA can reimburse eligible Marketplace premiums when the arrangement's requirements are satisfied. However, Internal Revenue Code Section 125(f)(3) prohibits using cafeteria plan salary reductions to purchase individual qualified health plans offered through an ACA Exchange.

An employee who accepts an ICHRA and purchases Marketplace coverage therefore generally pays any remaining premium using after-tax funds.

Marketplace coverage also introduces the question of premium tax credits, which may be available to eligible individuals who decline an unaffordable ICHRA.

The ICHRA, Section 125, and Premium Tax Credit Decision

If an employer offers an affordable ICHRA, the employee generally cannot receive Marketplace premium tax credits, even after declining the arrangement.

If the ICHRA is considered unaffordable, an otherwise eligible employee can choose between accepting the ICHRA or opting out and seeking Marketplace coverage with premium tax credits.

For an employee with an unaffordable ICHRA offer, the comparison may involve two different approaches.

The first is to accept the employer's ICHRA allowance, choose eligible off-Exchange coverage, and potentially use a Section 125 cafeteria plan to pay the remaining premium pre-tax.

The second is to decline the ICHRA, enroll through the Marketplace, and potentially receive premium tax credits based on the employee's household circumstances and applicable eligibility rules.

These options cannot be combined for the same coverage period. An employee cannot receive ICHRA reimbursements while also claiming Marketplace premium tax credits for that coverage.

The best financial outcome depends on several factors, including the employer allowance, available premiums, household income, tax circumstances, provider networks, and potential Marketplace assistance.

A pre-tax premium deduction is valuable, but it should be considered alongside the full cost of coverage and any Marketplace financial assistance the employee may qualify to receive.

Employers should communicate these distinctions clearly without directing employees toward a particular tax outcome.

How Section 125 Connects With Lirvion's Enrollment Paths

Enrollment is a core part of the employee experience under a CHOICE Arrangement.

Depending on the employer's configured setup, Lirvion supports three enrollment paths:

·       Quick Enroll: Off-Exchange enrollment through Lirvion, completed by the employee.

·       Auto Enroll: Authorize an agent to complete your enrollment for you. Coverage is not selected or activated without your participation.

·       Self Enroll: Independent enrollment through the Marketplace.

For employees using Quick Enroll, qualifying off-Exchange coverage may support Section 125 pre-tax treatment of the remaining premium when the employer has an appropriate cafeteria plan.

With Auto Enroll, the Section 125 treatment depends on the actual coverage purchased and the enrollment channel. Licensed-agent assistance does not itself determine whether a premium qualifies for pre-tax payroll deductions.

Employees using Self Enroll through the Marketplace generally cannot use Section 125 salary reductions toward their individual Marketplace premiums.

The distinction should be part of the employer's benefits communication before enrollment begins. Employees need to understand how their coverage decisions affect both their premium responsibilities and any available tax-preferred payment options.

ICHRA Funding Must Remain Employer-Funded

Although Section 125 and ICHRA can work together, they are governed by different funding rules.

An ICHRA is an employer-funded health reimbursement arrangement. Employee salary reductions cannot be used to finance the employer's ICHRA contribution.

A properly established cafeteria plan can separately allow eligible employees to pay qualifying off-Exchange premiums remaining after the ICHRA allowance.

For example, the employer in our earlier scenario provides the $450 ICHRA allowance from employer funds. The employee's remaining $150 may be handled through a qualifying Section 125 payroll deduction.

The employer must keep these arrangements properly structured and distinguish between employer reimbursement benefits and employee salary-reduction elections.

This separation is important for plan documentation, tax treatment, and ongoing administration.

What Employers Need Before Offering Pre-Tax Premium Deductions

Offering Section 125 premium deductions requires more than enabling a deduction in payroll software.

Employers need a compliant written cafeteria plan that defines eligibility, available benefits, election procedures, and other operating requirements. Payroll systems must also be configured to handle employee premium contributions correctly.

For employers transitioning from traditional group insurance to an ICHRA, some processes may already exist. Others may need to be updated to account for employees purchasing individual coverage through different channels.

A practical implementation should address the following questions:

1.          Is there a compliant written Section 125 plan? The employer needs appropriate plan documentation before offering pre-tax premium deductions.

2.          Which employees and premiums qualify? Eligibility depends on the cafeteria plan's terms and the insurance coverage purchased.

3.          How will the remaining premium be calculated? Employers must distinguish their ICHRA allowance from the employee's individual premium responsibility.

4.          How will payroll elections work? Section 125 election rules generally restrict midyear changes, with exceptions for permitted events and circumstances.

5.          What happens when premiums or coverage change? Employers need processes for new hires, premium adjustments, employment terminations, and other changes that may affect deductions.

6.          Who handles compliance? Cafeteria plan documentation, nondiscrimination testing, payroll tax treatment, and election administration require clearly assigned responsibilities.

7.          How will employees understand their options? Communications should explain the differences among ICHRA allowances, Section 125 deductions, and Marketplace premium tax credits.

These considerations should be addressed while the employer is designing its benefits program. Waiting until employees have completed enrollment can create unnecessary complications for payroll and ongoing administration.

An employer should also involve its payroll provider and qualified benefits or tax advisors in establishing the necessary procedures. The appropriate setup depends on the employer's existing payroll arrangements and the terms of its cafeteria plan.

How Lirvion Supports CHOICE Arrangement Administration

Lirvion provides nationwide premium-only CHOICE Arrangement (ICHRA) administration, helping employers manage defined allowances, verify individual health coverage, coordinate premium-related activity, and support monthly reconciliation and reporting.

The platform's premium administration model includes workflows for tracking employer allowances and premium payment responsibilities. Depending on the employer's configured payment setup, premium funding coordination may also involve amounts attributable to employees.

This visibility helps employers understand how premium obligations are divided between employer allowances and employee responsibilities, information that may be relevant when coordinating with payroll and a separate Section 125 administrator.

Lirvion also supports individual coverage enrollment through multiple paths, helping employers coordinate enrollment activity with ongoing benefits administration.

Employers remain responsible for implementing payroll deductions, applying the appropriate tax treatment, and maintaining compliance with their Section 125 cafeteria plans.