Premium conversion allows employees to pay their share of employment-based health insurance premiums on a pre-tax basis. Although plans vary, on average employers pay about 84% of the premium for single coverage and 73% of the premium for family coverage, leaving employees to pay the remaining portion. The employer share is always excluded from the employees' income and employment taxes (i.e., Social Security and Medicare taxes). In contrast, the employee share is paid either in after-tax dollars without premium conversion or in pre-tax dollars with it. Paying with pre-tax dollars results in tax savings for both the employee and the employer. For example, consider an employee whose share of the premium is $1,000. If the employee were in the 15% federal tax bracket, the employee would need to earn $1,293 in wages to have $1,000 left over after paying $194 in income taxes and $99 in employment taxes. With premium conversion, the $1,000 is not subject to taxes, reducing the taxable part of the $1,293 to $293 and income and employment taxes to $66, a tax savings of $227. To some, premium conversion seems like an accounting trick. It is difficult for people who are not tax experts to follow the calculations or understand the rationale. Rules limiting its use strike some as arbitrary and unfair. Premium conversion is sometimes referred to as premium only or section 125 plans, causing further confusion. This report provides more explanation of premium conversion and requirements for its use. It summarizes the statutory and regulatory background and briefly discusses whether it is sound public policy. Finally, it discusses two policy issues, whether premium conversion should include retirees and what role it might play in health care reform. Premium conversion is authorized by section 125 of the Internal Revenue Code, a section entitled "cafeteria plans." In general, the section allows taxpayers to choose among taxable and nontaxable benefits offered by an employer without paying taxes if they select the latter. As a rule under tax law, when taxpayers are offered a choice between taxable and normally nontaxable income they will be taxed on whichever they choose; they will be deemed to be in "constructive receipt" of the taxable income whether or not they take it. Section 125 makes an exception to the constructive receipt rule for benefits such as health insurance that meet the section's requirements. Cafeteria plans can be established only by employers. They must always offer a choice of taxable and nontaxable benefits. The taxable benefit usually offered is cash, but it might include benefits normally purchased with after-tax dollars, such as group term life insurance. Allowable nontaxable benefits include accident and health insurance, health care flexible spending accounts, accidental death and dismemberment insurance, dependent care assistance, adoption assistance, and others. Certain nontaxable employer benefits may not be offered, such as scholarships, education assistance programs, and long-term care insurance or services. In addition, cafeteria plans cannot offer benefits that defer compensation to a later year aside from 401(k) account contributions. Short carryover periods (i.e., several months) are permitted. Some cafeteria plans offer employees choices among a number of benefits (hence the name), whereas others limit the choice to cash and one specific nontaxable benefit. Premium conversion is an example of the latter. It is possible for employers to offer both premium conversion and a separate plan with choices among other benefits. The cash option may be wages. Under salary reduction agreements, employees in effect agree to work for reduced wages in exchange for having their employer provide an equivalent amount of nontaxable benefits. Premium conversion uses these agreements: employees are given the choice of receiving taxable wages or reducing their wages by their share of the health insurance premium ($1,000 in the earlier example) and having the employer use that sum to pay the premium. Taxable wages are thus converted to an employer payment for a nontaxable benefit. Premium conversion can apply both to health plans chosen by employers (which is the usual case) as well as insurance that individual workers obtain on their own. If employers allow the latter, they must ensure that payments they make in fact are used for health coverage. Like all cafeteria plans, premium conversion plans must be in writing. They must be limited to employees, though former employees may be included provided the plan is not maintained predominantly for them. Employee elections must be irrevocable for the plan year aside from changes due to changes in family status, in alternative coverage for family members, and other limited circumstances. Employers must file a report each year with the Department of Labor; separate IRS reporting requirements were suspended in 2002. All cafeteria plans must meet nondiscrimination tests. Plans may not discriminate in favor of highly compensated employees with respect to eligibility to participate, nor as to employer contributions or actual use of benefits. In addition, the nontaxable benefits of key employees cannot exceed 25% of the aggregate nontaxable benefits provided all employees under the plan. Finally, cafeteria plans must comply with the nondiscrimination requirements for the benefit in question. Thus, coverage under employers' self-insured accident and health plans must meet the additional nondiscrimination standards in section 105(h). Section 125(g) includes a safe-harbor test (a simplified test providing one way to meet the standards) for all accident and health plans, and the proposed regulations include another for premium-only plans. Nonetheless, applying the rules can be complex if not all employees are allowed to participate (e.g., part-time workers), if many eligible workers do not participate, or if participants choose different benefits. The complexity of nondiscrimination rules is one reason that small firms generally do not use cafeteria plans. In particular, the rule regarding key employees would preclude use by many small companies since those employees would often account for more than 25% of the nontaxable benefits. The complexity contributes to the administrative cost of establishing plans and ensuring they remain in compliance. In addition, owners of small businesses reportedly are reluctant to establish cafeteria plans if they are sole proprietors, partners, or more than 2% owners of S-corporations. These owners are not classified as employees under the tax code and thus cannot participate in employee benefit programs. Section 125 was included in the Internal Revenue Code by the Revenue Act of 1978 ( P.L. 95-600 ). It has been amended a number of times, especially in the first decade after enactment. Nearly all of the current text consists of provisions dealing with qualified benefits and nondiscrimination. Detailed rules regarding cafeteria plans appear not in the statute but in IRS guidance, particularly proposed rules issued in 1984 and 1989. These rules were never finalized, but they remained the position of the IRS and employers relied upon them. The 1984 and 1989 rules were withdrawn when the IRS issued comprehensive proposed rules on August 7, 2007. Benefit choice did not originate with section 125 or the IRS guidance; instead, the statutory and regulatory rules were in response to plans starting to spread among employers. In particular, there reportedly was an increase in employers offering cash-or-deferred arrangements (CODAs), which allow workers to choose between receiving cash or having employers contribute to a qualified retirement trust without being taxed on the latter until withdrawals occur in later years. The IRS had previously issued revenue rulings supporting these arrangements, but in 1972 it proposed to tax workers at the time of the contribution if it were made in return for a reduction in wages or in lieu of an increase in wages. In response, Congress included a provision in the Employee Retirement Income Security Act of 1974 (ERISA, P.L. 93-406 ), that temporarily blocked application of the proposed rule for plans in existence on June 27, 1974, until it could study the issue. The provision was extended several times before the Revenue Act of 1978 added section 125. The conference report on ERISA explicitly states that the provision applied not just to CODAs but also to cafeteria plans. Although neither ERISA nor section 125 mentions premium conversion, they establish authority for its tax treatment. Premium conversion probably became more common after the 1970s when, in the face of rising costs, employers sought to limit health plan contributions and help employees manage their own. Employers might obtain results similar to premium conversion by restricting wage growth and using the savings to increase what they pay for premiums. Many probably follow this strategy even if they are reducing the percentage of the premium they pay (i.e., they are still increasing the dollar amount of their contributions). For workers who have employer-provided health care, the effect of premium conversion and restrictions on wage growth could be roughly the same, depending on how the employer changes the wage levels (it might not be the same dollar amount for all workers). However, restrictions on wage growth would be less advantageous for workers who decline employment-based coverage, either because they do not value it highly or because they have better coverage through a spouse. Only premium conversion allows them the flexibility to individually opt out of a wage reduction that otherwise would be imposed across the board. Whether premium conversion is sound public policy has received little attention. It might be criticized since workers' tax savings depend upon their marginal tax rate, allowing higher-income workers to benefit more. In addition, because only employees are eligible for premium conversion, people who purchase insurance on their own cannot benefit. However, these criticisms apply generally to the exclusion for employer-provided health insurance, of which premium conversion is a minor part. If one were concerned solely about equity, one might limit or end the entire exclusion, not just premium conversion. Moreover, if only premium conversion were limited, employers could always obtain the same tax benefits for themselves and most of their employees by restricting wage growth and using the savings to pay premiums, as described in the previous paragraph. In recent years, the principal premium conversion issue before Congress has been whether it should be extended to federal retirees. If health care reform were enacted, consideration may also be given to what role premium conversion might play. Retirees sometimes complain that they cannot take advantage of premium conversion. The barrier is not section 125, for as indicated above cafeteria plans may include former employees provided the plan is not maintained predominantly for them. Instead, the restriction is due to an IRS determination that distributions from qualified retirement plans are always subject to taxes, aside from several minor exceptions. The IRS ruling precludes former employees from recasting pension payments as pretax income, as active workers can recast their wages. It might appear that this rule is unfair to retirees since in general their income is lower than current workers who have premium conversion. The outcome seems to conflict with the equity principles underlying cafeteria plan nondiscrimination rules. However, it is important to recognize that employer payments for retiree health insurance are excluded from taxes, just as they are for active workers. For many retirees, the employer pays much of the premium and tax savings on this share would generally be two to three times the additional tax savings from premium conversion. While allowing retirees the additional advantages of premium conversion would treat them like active workers, it would then seem even more unfair to retirees without access to employer coverage. The latter retirees are likely to have lower incomes yet. In the 111 th Congress, H.R. 1203 (Van Hollen) and S. 491 (Webb) would allow federal retirees to pay their share of Federal Employees Health Benefits Program (FEHBP) premiums on a pre-tax basis. Besides the equity discussion in the previous paragraph, it might seem difficult to justify extending premium conversion to federal retirees and not retirees with private sector or state or local government retiree health insurance. Extending premium conversion to other retiree groups would greatly increase the revenue loss of this proposal. Massachusetts enacted a broad health care reform law in April 2006 called Chapter 58. Among other things, the law requires employers with 11 or more full-time equivalent (FTE) workers to establish premium conversion plans, which it calls section 125 plans. The plans must be set up whether or not employers offer health insurance and whether or not they contribute to the cost of coverage. As mentioned above, premium conversion is allowed for insurance that individual workers obtain provided employers ensure that payments they make (including those by premium conversion) in fact are used for that purpose. The Massachusetts provision benefits workers of employers that previously had not offered premium conversion or extended it to all workers. Their employers would also save on employment taxes. The public cost of the provision is borne primarily by the federal government through reduced income and employment tax revenue, though Massachusetts would experience a small reduction in its own income tax revenue. Chapter 58 also requires employers with 11 or more FTE workers to make a fair contribution to their health insurance costs or pay a penalty of $295 per worker. Some observers think that once the reforms are well established smaller employers may be asked to make some contribution and set up premium conversion arrangements. However, some small employers might have difficulty meeting the nondiscrimination requirements that were described above. Massachusetts cannot by itself exempt employers from federal requirements. A similar requirement for premium conversion might be considered in the reform legislation now before Congress. The tax savings could help employers and employees pay for the coverage that would be available through the exchanges the bills envision. Unlike Massachusetts, however, which could obtain an additional federal subsidy at little cost, the federal government would be the primary payer for this benefit. In addition, some in Congress are considering limiting the tax exclusion for employer-provided coverage, not expanding it. If Congress were to require or encourage employers to adopt premium conversion, consideration may be given to enabling more small businesses to take advantage of it. Legislation introduced in the 111 th Congress by Senator Snowe ( S. 988 , the SIMPLE Cafeteria Plan Act of 2009) would remove some of the barriers discussed above. If premium conversion were included in health care reform, consideration may also be given to modifying the statutory and regulatory nondiscrimination rules. As described above, premium conversion is covered by rules applying to cafeteria plans generally, though the August 2007 proposed IRS rules would allow a simplified test. These rules originate in a concern reflected in a number of parts of the tax code that people with high income or influence over employer policies can take advantage of nontaxable benefits while others cannot. For example, if low-wage workers cannot afford to give up cash wages, then most of the tax subsidy associated with nontaxable benefits would accrue to higher-paid workers. Health care reform legislation now before Congress could change these circumstances: for example, the principal proposals now being considered would require everyone to have health insurance, making it no longer an option, and lower-income taxpayers would receive premium subsidies of some sort. Congress may consider establishing separate nondiscrimination rules for premium conversion that takes account of the new proposed subsidies.

Summary: Premium conversion allows employees to pay their share of employment-based health insurance premiums on a pre-tax basis. The tax treatment is difficult for people who are not tax experts to understand, as are the rules that limit its use in a manner some consider arbitrary and unfair. Premium conversion is sometimes referred to as "premium only" or "section 125 plans," causing further confusion. Premium conversion is authorized by section 125 of the Internal Revenue Code, a section entitled "cafeteria plans." In general, the section allows taxpayers to choose among taxable and nontaxable benefits offered by an employer without paying taxes if they select the latter. As a rule under tax law, when taxpayers are offered a choice between taxable and normally nontaxable income they will be taxed on whichever they choose. Section 125 makes an exception to this rule for benefits such as health insurance that meet the section's requirements. Some cafeteria plans allow workers to choose among a number of benefits (hence the name), though others allow only a choice between cash and one nontaxable benefit. Premium conversion is restricted in this manner, with cash being in the form of wages that are not given up and health insurance being the one nontaxable benefit. Employers that offer premium conversion may also offer separate cafeteria plans with other choices. All cafeteria plans must be in writing and meet a number of nondiscrimination rules regarding highly compensated employees and company officers and owners. The rules are complex, and some make it difficult for small businesses to have the plans. Section 125 was included in the tax code in 1978, but it is not clear when employers began adopting premium conversion. It likely became more common as rising health care costs led employers to limit their insurance contributions and to help employees manage their own. Employers might obtain results similar to premium conversion by restricting wage growth and using the savings to increase what they pay for premiums. However, only premium conversion allows workers the flexibility to individually choose this outcome. Retirees sometimes complain that they cannot take advantage of premium conversion. The barrier is not section 125 but an IRS determination that distributions from qualified retirement plans are always subject to taxes, aside from several minor exceptions. Legislation, H.R. 1203 (Van Hollen) and S. 491 (Webb), has been introduced in the 1111th Congress to allow premium conversion for federal retirees. In its 2006 health care reform legislation, Massachusetts required all employers with 11 or more full-time equivalent workers to adopt premium conversion. Consideration might be given to whether a similar requirement might be included in health care reform legislation now before Congress. If it is included, Congress might also consider making it easier for small businesses to establish premium conversion, as it might establishing separate nondiscrimination rules for it. However, some in Congress are considering limiting the tax exclusion for employer-provided coverage, not expanding it; presumably they would not favor extending premium conversion to more employees.