Question: Can an employee change a health plan election to a lower-cost option or revoke coverage altogether based on financial hardship?
Employees elect to pay the employee-share of the health plan premium on a pre-tax basis through the employer’s Section 125 cafeteria plan. As described in more detail below, employees cannot change their Section 125 elections mid-year unless they experience a permitted election change event.
Section 125: Irrevocable Election Requirement
That general rule under Section 125 for ongoing employees is that all elections (including an election not to participate) must be:
1) Made prior to the start of the plan year, and
2) Irrevocable for the plan year unless the employee experiences a permitted election change event.
The permitted election change events are set forth in Treas. Reg. §1.125-4. “Financial hardship” (or anything of that nature) is not one of the permitted election change events.
The ABD Section 125 Cafeteria Plan Permitted Election Change Event Chart summarizes the life events that may create a permitted election change event once the plan year begins.
If an employer’s cafeteria plan were to permit employees to make any mid-year election changes without experiencing a permitted election change event (or without making the election change within plan’s timing window, which is generally 30 days), the plan would violate the irrevocable election rules described above. The Section 125 rules state that if the discrepancy were discovered, the IRS could cause the entire cafeteria plan to lose its tax-advantaged status—resulting in all elections becoming taxable for all employees.
Employees with a financial hardship will need to experience one of the permitted election change events (summarized here) in order to change their current health plan election, including to revoke coverage themselves, a spouse, and/or children.
Prop. Treas. Reg. §1.125-1(c)(7)(ii)(F):
(7) Operational failure.
(i) In general. If the cafeteria plan fails to operate according to its written plan or otherwise fails to operate in compliance with section 125 and the regulations, the plan is not a cafeteria plan and employees’ elections between taxable and nontaxable benefits result in gross income to the employees.
(ii) Failure to operate according to written cafeteria plan or section 125. Examples of failures resulting in section 125 not applying to a plan include the following—
(A) Paying or reimbursing expenses for qualified benefits incurred before the later of the adoption date or effective date of the cafeteria plan, before the beginning of a period of coverage or before the later of the date of adoption or effective date of a plan amendment adding a new benefit;
(B) Offering benefits other than permitted taxable benefits and qualified benefits;
(C) Operating to defer compensation (except as permitted in paragraph (o) of this section);
(D) Failing to comply with the uniform coverage rule in paragraph (d) in §1.125-5;
(E) Failing to comply with the use-or-lose rule in paragraph (c) in §1.125-5;
(F) Allowing employees to revoke elections or make new elections, except as provided in §1.125-4 and paragraph (a) in §1.125-2;
(G) Failing to comply with the substantiation requirements of § 1.125-6;
(H) Paying or reimbursing expenses in an FSA other than expenses expressly permitted in paragraph (h) in §1.125-5;
(I) Allocating experience gains other than as expressly permitted in paragraph (o) in §1.125-5;
(J) Failing to comply with the grace period rules in paragraph (e) of this section; or
(K) Failing to comply with the qualified HSA distribution rules in paragraph (n) in §1.125-5.
Prop. Treas. Reg. §1.125-2(a)(1):
(a) Rules relating to making and revoking elections.
(1) Elections in general. A plan is not a cafeteria plan unless the plan provides in writing that employees are permitted to make elections among the permitted taxable benefits and qualified benefits offered through the plan for the plan year (and grace period, if applicable). All elections must be irrevocable by the date described in paragraph (a)(2) of this section except as provided in paragraph (a)(4) of this section. An election is not irrevocable if, after the earlier of the dates specified in paragraph (a)(2) of this section, employees have the right to revoke their elections of qualified benefits and instead receive the taxable benefits for such period, without regard to whether the employees actually revoke their elections.
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