When employees without group health insurance buy individual coverage, they do so using after-tax income--costing them from 20% to 50% more than others pay for equivalent coverage. Prior to the passage of the Patient Protection and Affordable Care Act (PPACA), several states promoted a potential solution that would allow employees to buy individual insurance through tax-sheltered payroll deduction. This technical but creative approach would allow insurers to combine what is known as "list-billing" with a Section 125 "cafeteria plan." However, these state-level reform attempts have failed to gain significant traction because state small-group reform laws and federal restrictions on medical underwriting cloud the legality of tax-sheltered list-billing. Several authorities have taken the position that insurance paid for through a cafeteria plan must meet the nondiscrimination requirements of the Health Insurance Portability and Accountability Act with respect to eligibility, premiums, and benefits. The recently enacted Patient Protection and Affordable Care Act addresses some of the legal uncertainty in this area, but much remains. For health reform to have its greatest effect, federal regulators must clarify whether individual health insurance can be purchased on a pre-tax basis through a cafeteria plan.
It is a conspicuous anomaly in the United States that premiums for most private health insurance are excluded from taxable income, but not for the fairly small percentage of people who buy individual coverage outside the workplace. This differential tax treatment effectively increases the cost of individual coverage 20% to 50% or more. The Patient Protection and Affordable Care Act of 2010 (PPACA) changes much about the way health insurance is bought and paid for, but this differential tax treatment remains. Nevertheless, making insurance more affordable is one of PPACA's central aims and is critical to the success of its individual mandate.
One possible way for people with individual coverage to obtain the same tax benefits as employees is to pay for individual insurance through payroll deduction using a "cafeteria plan." Authorized by Section 125 of the Internal Revenue Code, cafeteria plans permit employers to offer voluntary benefits on a pre-tax basis. Many of us are familiar with flexible spending accounts that reimburse out-of-pocket medical costs with pre-tax dollars. Section 125 plans also may be used to pay health insurance premiums. This is what allows employed individuals to pay their share of group premiums on a pre-tax basis.
Usually only larger employers offer cafeteria plans with a full menu of benefits, but Section 125 cafeteria plans can also be set up for a single purpose such as paying health insurance premiums. These "premium-only cafeteria plans" are relatively simple to create and administer. Therefore, they are fairly ubiquitous as an adjunct to employer-sponsored group health insurance. Less common is their use solely as a pre-tax mechanism to pay for individual insurance without employer contributions.
Prior to PPACA, several states sought to capitalize on the tax advantages of Section 125 plans by requiring or encouraging all employers to offer a cafeteria plan for the pre-tax payment of health insurance premiums, even if the employer did not sponsor a group health plan (Hall, Hager, and Orentlicher 2010). For reasons discussed later, these state efforts involved significant legal uncertainty. Specifically, there was concern that paying for health insurance through a cafeteria plan creates a "group health plan" for purposes of the Health Insurance Portability and Accountability Act of 1996 (HIPAA). Group health plans are prohibited under HIPAA from using health status to determine eligibility, premiums, or benefits. Therefore, it was legally unclear whether cafeteria plans could be used to fund medically underwritten health insurance without violating HIPAA. …