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.