Does dropping health coverage jeopardize qualified status?

[Guest Jensen]

Confession up front -- I have not done any research on this yet, so I apologize if the answer is obvious!

We have a cafeteria plan that includes health, dental, FSA and dependant care. An employee recently asked to drop her family health coverage for a reason that is not a qualifying status change (e.g. marriage/divorce/job change etc.). The coverage was started in July, so there are approximately 6 months to go before the end of the 12 month commitment. Our TPA has advised us that allowing this employee to drop health coverage prior to the conclusion of the 12 month period would jeopardize the qualified status of the entire cafeteria plan, and if it was caught, all of the pre-tax contributions ever made to the plan, by any employee would become taxable.

I understand that if the plan loses its qualified status, it affects the entire plan and all participants. And I know that an employee cannot get into the plan, absent a qualifying status change, in the middle of the year. But is it correct that allowing an employee to discontinue health ins. coverage in the middle of the year would throw the entire plan out of compliance?

Thanks!

[Guest jrodgers32]

Confession up front -- I have not done any research on this yet, so I apologize if the answer is obvious!

We have a cafeteria plan that includes health, dental, FSA and dependant care. An employee recently asked to drop her family health coverage for a reason that is not a qualifying status change (e.g. marriage/divorce/job change etc.). The coverage was started in July, so there are approximately 6 months to go before the end of the 12 month commitment. Our TPA has advised us that allowing this employee to drop health coverage prior to the conclusion of the 12 month period would jeopardize the qualified status of the entire cafeteria plan, and if it was caught, all of the pre-tax contributions ever made to the plan, by any employee would become taxable.

I understand that if the plan loses its qualified status, it affects the entire plan and all participants. And I know that an employee cannot get into the plan, absent a qualifying status change, in the middle of the year. But is it correct that allowing an employee to discontinue health ins. coverage in the middle of the year would throw the entire plan out of compliance?

Thanks!

According to Reg. 1.125-4, she may not change her election with a change in status (www.indstate.edu/humres/docs/Section125-4.pdf). There are more situations than those you have listed above that qualify, however, so whatever her motivation is to get rid of her coverage should be examined carefully to see if it does qualify. If she just doesn't want to buy health insurance for her family anymore, that does not qualify and does jeopardize the plan. Another thing to consider is that allowing this mid year non-qualified change may violate your company's contract with its health insurer, as it creates a moral hazard by allowing people who use less health care to quit the program, thus worsening the retained premium ratio for the health insurer.

[Guest Jensen]

Thanks!

[Guest erinf]

Not to quibble, but I think you would have to distinguish between dropping coverage and making a change in election. An employee can drop coverage at any time, but cannot change the FSA election without a change in status. The practical effect to the employee is that he'd be witholding income and getting no benefit from it, so of course no one informed of this would rationally still choose to drop coverage. However, it is incorrect to say you can't drop coverage - you can, you just can't change your election without a change of status.

[Guest SHaddon]

Not to quibble, but I think you would have to distinguish between dropping coverage and making a change in election. An employee can drop coverage at any time, but cannot change the FSA election without a change in status. The practical effect to the employee is that he'd be witholding income and getting no benefit from it, so of course no one informed of this would rationally still choose to drop coverage. However, it is incorrect to say you can't drop coverage - you can, you just can't change your election without a change of status.

Not so. A participant may not drop coverage at any time if the premiums are run through a cafeteria plan pre-tax. To do so jeopardizes the plan.

[QDROphile]

SHaddon: I don't think you understand. The cafeteria plan election is not changed and the employee's compensation is still reduced by the same amount. The cafeteria plan does not perceive any change, so no violation occurs. The insurance company sees a change. Less coverage, less premium, assuming that the policy allows mid-year disenrollment. The employer benefits to the extent of the reduced premium.

You may be used to the cafeteria plan as the vehicle for health plan coverage election, but the health coverage election is not actually part of a section 125 plan. The section 125 aspect is only concerned with the salary reduction election.

[leevena]

SHaddon, I agree with QDROphile. The employee can drop their health coverage, and the deductions must continue.

[J Simmons]

I agree with QDROphile and leevena--since you've indicated that the employee made a 12-month commitment. The distinction they are drawing is between the cafeteria plan and the health insurance coverage. The cafeteria plan is a mechanism for paying for the health insurance coverage. The cafeteria plan is distinguishable from the health insurance coverage itself.

An employee can only make a cafeteria plan change (i.e., a change in election for payroll reduction and to which benefits the reduced amount will be applied in payment) mid-"period of coverage" if there is (and then only to the extent consistent with) certain changes in status spelled out in the regulations. Regs 1.125-4, 1.125-2, Q&A-6.

Reg 1.125-1, Q&A-8 provides that a "plan may provide that elections may be made at any time" in accordance with certain guidelines (see Q&A-15) to avoid taxation due to constructive receipt. It won't be an 'election' if the employee can change it after the period of coverage has begun but before it has ended (except for a Reg 1.125-4 specified change in status mid-period of coverage). If the employee is otherwise permitted to revoke the 'election' after the period of coverage has begun but before it ends, that power of revocation is constructive receipt of the taxable income. Reg 1.125-1, Q&A-15. So to be valid, the election must be made before the period of coverage begins and the election must be irrevocable once the period of coverage begins (but for a Reg 1.125-4 specified change in status mid-period of coverage).

Jensen spelled out that it was a 12-month commitment by the employee in the election. But that should not be assumed as required when designing a plan. Granted, the 'period of coverage' for a health flex account must generally be a 12-month period. Reg 1.125-2, Q&A-7(b)(3). For any and all other permissible benefits, the regs don't specify. Thus the plan can be drafted to specify different 'periods of coverage' for benefits other than a health flex account.

If the plan Jensen mentions is amended, for future purposes, to provide that the insurance-coverage benefits are for 'periods of coverage' of a month each, then the election form can be made to evergreen the election into successive months until the employee stops it. If an employee stops or changes the election, that would take effect at the beginning of the next month after so stopping or changing the election. As jrodgers32 mentioned, this might cause some the health insurer concerns about the premium ratio. It would also increase administrative tasks and burden on payroll. But it would also give some flexibility to the insured benefits that most cafeteria plans simply don't permit, but could.

If you have a premium only plan (POP), this latitude can be particularly useful without engendering additional confusion among employees.

The cafeteria plan may also allow for different periods of coverage for day care flex accounts than the typical 12-month period so many plans use. One plan I've reviewed used Jan-May, June-August, Sept-Dec as periods for day care flex, reasoning that this reflected differences when children may be in school or on summer break, and when the other spouse may be attending college for a semester at a time.