In the United States, a HSA (health savings account) cafeteria plan is a formal employee benefit plan established under Section 125 of the Internal Revenue Code that allows employees to make tax-free contributions to an individual health savings account. Such a structure is highly tax beneficial, allowing the employee to fund medical costs while incurring virtually no federal taxation on amounts used for payment.
Section 125 Plans
Section 125 of the Internal Revenue Code allows employers to provide benefits to employees on a pretax basis. Employees do not need to pay federal income tax or Social Security and Medicare taxes on contributions to Section 125, and employers can avoid paying Social Security and Medicare taxes on the amount of employee contributions. Because of the wide range of plans and benefits available under Section 125, the formal, written plans established by employers under this section of the Internal Revenue Code are known commonly as cafeteria or flexible benefit plans.
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Health Savings Accounts - General
HSAs are a form of tax beneficial savings plan for medical costs. In regard to both tax benefit and individual account control, they function similarly to individual retirement accounts (IRAs). Taxpayers may exclude contributions to a health savings account from federal income taxation. The taxpayer funding the HSA is free to select from a wide range of investment options, often including investment categories from cash equivalents and stock funds. Investments within a HSA then grow tax-free.
Health Savings Accounts - Distributions
HSAs have an additional tax benefit at distribution that makes them superior to traditional IRAs in terms of tax benefit. Distributions from health savings accounts used for qualified medical expenses are not subject to tax. Non-qualified distributions after Jan. 1, 2011 are subject to a 20 percent penalty, although this is not assessed on taxpayers age 65 and older. All non-qualified distributions are subject to inclusion for federal income tax purposes, regardless of age.
Tax Benefit of Contributing
While HSAs are available to all taxpayers enrolled in a high deductible health insurance plan, the benefit to employees contributing to an HSA through a Section 125 plan is significant. While both contributors inside and outside a Section 125 plan do not pay federal income tax on contributions, contributors inside a Section 125 plan can avoid Social Security and Medicare taxes that typically equal 7.65 percent of all contributions.