Using payroll deduction to shelter individual health insurance from income tax

Abstract

Objective: To assess the impact of state laws requiring or encouraging employers to establish "section 125" cafeteria plans that shelter employees' premium contributions from tax.

Data sources: Available descriptive statistics, 65 key-informant interviews, and relevant documents in study states and nationally, 2008-2009.

Study design: Case studies were conducted in Indiana, Massachusetts, and Missouri--three states adopting laws in 2007. Descriptive quantitative information came from insurers, regulators, and surveys of employers. In each state, 15-17 semistructured but open-ended interviews were conducted with insurance agents, insurers, government officials, and third-party administration firms, and 29 informed sources were interviewed from a national perspective or other states. Key informants were selected based on their known or reported experience, in a "snowball" fashion until saturation was reached. Interview notes were coded for systematic analysis. Finally, relevant rulings, brochures, instructions, marketing materials, and other documents were collected and analyzed.

Findings: Despite the potential for substantial cost savings, use of section 125 plans to purchase individual insurance remained low in these states after 1 or 2 years. Absent a mandate, few employers were strongly motivated to offer these plans in order to retain an adequate workforce, and uncertainty about federal legality deterred doing so. For smaller employers, benefits to owners did not outweigh administrative complexities. Nevertheless, few downsides were found to states mandating or encouraging these plans. In particular, there is little evidence that many employers dropped group coverage as a result.

Conclusions: Section 125 plans remain a limited tool for states to reduce the inequitable tax treatment of individually purchased insurance, but a complete remedy requires reform of federal tax law.

Figure 1

Tax Rates—Federal Plus State Single, 2009 Assumes state/local rate of 5 percent. Federal rate includes 7.65 percent FICA tax.

Figure 2

Potential Marginal Tax Rates Facing a Single Parent with Two Children (Negative Rates Not Displayed) (2008)^{* *}Assumes that the state levies an income tax and has a state EITC (most advantageous scenario). Adapted from Quincy (2008b)(reprinted with permission).