Section 125 vs. HSA: Which Is Right for Your Business?

Understanding the Basics

What Is a Section 125 Cafeteria Plan?

A Section 125 cafeteria plan is an employer-sponsored benefits program that allows employees to pay for qualified benefits with pre-tax dollars. The term "cafeteria" comes from the menu of benefit options employees can choose from.

Common benefits offered through Section 125 plans include:

• Health insurance premiums
• Hospital indemnity insurance
• Flexible Spending Accounts (FSAs)
• Dependent care assistance
• Dental and vision coverage

What Is a Health Savings Account (HSA)?

An HSA is a tax-advantaged savings account that individuals can use to pay for qualified medical expenses. HSAs are only available to people enrolled in a High Deductible Health Plan (HDHP).

Key features of HSAs:

• Contributions are tax-deductible
• Earnings grow tax-free
• Withdrawals for qualified medical expenses are tax-free
• Funds roll over year to year
• Account is owned by the individual, not the employer

Side-by-Side Comparison

Tax Benefits Comparison

Section 125 Tax Benefits

Both employers and employees benefit from tax savings:

For employers:

• Save 7.65% FICA taxes on all pre-tax contributions
• Save on FUTA (up to 0.6%)
• Save on state unemployment taxes
• Potential workers' comp premium reduction

For employees:

• Save on federal income tax (10-37% depending on bracket)
• Save on state income tax (where applicable)
• Save 7.65% on FICA taxes

HSA Tax Benefits

HSAs offer "triple tax advantages":

• Tax-deductible contributions: Contributions reduce taxable income
• Tax-free growth: Any investment earnings are not taxed
• Tax-free withdrawals: Qualified medical expense withdrawals are tax-free

If HSA contributions are made through payroll deduction (via a Section 125 plan), employers also save FICA taxes on those contributions.

Eligibility Requirements

Section 125 Eligibility

Section 125 plans are broadly accessible:

• Available to any W-2 employee
• No health plan requirements (for most benefits)
• Owners/partners of pass-through entities generally cannot participate
• Must meet nondiscrimination requirements

HSA Eligibility

HSAs have stricter requirements:

• Must be enrolled in a qualifying High Deductible Health Plan
• Cannot be enrolled in Medicare
• Cannot be claimed as a dependent on someone else's tax return
• Cannot have other non-HDHP health coverage (with some exceptions)

Important: Many employees don't qualify for HSAs because they're not enrolled in an HDHP. Section 125 plans with hospital indemnity insurance have no such restrictions.

Flexibility and Use of Funds

Section 125 Flexibility

How funds can be used depends on the specific benefit:

• Hospital indemnity: Cash benefits paid directly to employee—can be used for ANY purpose
• Health FSA: Must be used for qualified medical expenses
• Dependent Care FSA: Must be used for qualifying dependent care
• Premium payments: Applied directly to insurance premiums

HSA Flexibility

HSA funds must be used for qualified medical expenses to avoid taxes and penalties:

• Doctor visits, hospital stays, surgery
• Prescription medications
• Dental and vision care
• Medical equipment
• Some over-the-counter medications

Non-qualified withdrawals are subject to income tax plus a 20% penalty (unless over age 65).

Rollover Rules

Section 125 Rollover

Rollover rules vary by benefit type:

• Hospital indemnity: Not applicable (benefits paid when events occur)
• Health FSA: "Use it or lose it" with limited exceptions (up to $640 rollover or 2.5-month grace period)
• Dependent Care FSA: Generally use it or lose it

HSA Rollover

HSAs have a significant advantage here:

• Funds roll over indefinitely
• No "use it or lose it" rule
• Can accumulate over years for future medical expenses
• Can be used in retirement for any purpose (taxed as income if non-medical after 65)

Which Is Better for Employers?

Both options reduce payroll taxes, but they serve different purposes:

Choose Section 125 with Hospital Indemnity If:

• You want to maximize payroll tax savings immediately
• Many employees don't have HDHP coverage
• You want a zero-cost benefits solution
• You have a large hourly workforce
• Employee retention is a priority
• You want simple, turnkey administration

Choose HSA If:

• You already offer a High Deductible Health Plan
• Employees want long-term savings vehicles
• You want to encourage healthcare consumerism
• Employees are comfortable managing investment accounts

Best of Both Worlds

Here's the good news: you don't have to choose. Many employers offer BOTH options:

• HSAs for employees enrolled in the HDHP
• Section 125 hospital indemnity for all employees (including those with HDHP)
• Maximum tax savings for both employer and employees

Which Is Better for Employees?

From an employee perspective, the best choice depends on individual circumstances:

Section 125 Hospital Indemnity Benefits Employees Who:

• Want immediate, tangible benefits
• Prefer cash payments they can use for anything
• Don't have an HDHP
• Want supplemental coverage beyond major medical
• Don't want to manage an investment account

HSAs Benefit Employees Who:

• Are enrolled in an HDHP
• Can afford to save for future medical expenses
• Want a retirement savings vehicle
• Are comfortable with investment decisions
• Have predictable, manageable healthcare costs

Implementation Considerations

Section 125 Implementation

• Requires written plan document
• Annual nondiscrimination testing required
• Must be employer-sponsored
• Third-party administration recommended
• Typical timeline: 30-60 days

HSA Implementation

• Must offer qualifying HDHP
• Employees open individual HSA accounts
• Can be offered through payroll deduction (via Section 125)
• Employer contributions are optional
• Account custodian/administrator needed

Our Recommendation

For most businesses we work with, a Section 125 cafeteria plan with hospital indemnity insurance provides the best combination of:

• Maximum employer tax savings (7.65%+ on all contributions)
• Broad employee eligibility (no HDHP requirement)
• Zero out-of-pocket cost (program funds itself)
• Tangible employee benefits (cash when they need it)
• Simple administration (we handle everything)

If you already offer an HDHP and HSA, adding hospital indemnity through Section 125 provides even more value—employees can use indemnity benefits to fund their HSA contributions or cover HDHP deductibles.