	Introduction

Premium conversion allows employees to pay their share of employment-based health insurance premiums on a pre-tax basis. 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. Premium Conversion Basics

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. 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. Like all cafeteria plans, premium conversion plans must be in writing. 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. Retirees

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. 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. 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. A similar requirement for premium conversion might be considered in the reform legislation now before Congress. 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. If premium conversion were included in health care reform, consideration may also be given to modifying the statutory and regulatory nondiscrimination rules. Congress may consider establishing separate nondiscrimination rules for premium conversion that takes account of the new proposed subsidies.
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.