Generally, fixed indemnity health plans are used to supplement coverage under a group medical plan. A fixed indemnity plan should be a type of excepted benefit that provides tax free cash payments to participants and beneficiaries. However, it’s easy to botch the tax benefits and unintentionally subject these indemnity plans to ERISA. Fixed indemnity health plans are intended to provide cash payments for specific illnesses or injuries. For example, if an employee is admitted to the hospital for a serious illness, a fixed indemnity plan may pay $1,000, regardless of the amount of the expenses incurred. These payments are often money when the employee needs it the most so it’s important that the employe gets that $1,000, not what’s left after taxes.
Funding fixed indemnity benefits through a cafeteria plan will make cash payments taxable as ordinary income. Last December, the IRS issued a Memorandum that provided guidance on the tax treatment of payments from fixed indemnity health plans. According to the IRS, whether cash payouts from a fixed indemnity health plan are taxed as ordinary income depends on how the premiums are paid. If the premium payments are paid by employees on an after-tax basis, the benefit payments are not taxed. Alternatively, if the coverage under the fixed indemnity plan is funded by the employer (on a tax-free basis) or on a pre-tax basis through a Cafeteria/Section 125 plan, payments from the plan must be included in the employee’s gross income and wages. Let’s consider how this distinction impacts an employee who gets seriously ill and is forced to make a trip to the emergency room, an event for which the indemnity plan provides a fixed benefit of $1,000. So long as the premiums were paid by the employee on an after-tax basis, the employee gets $1,000 (tax free) even if her unreimbursed medical costs were only $800. But, if that same $1,000 benefit is subject to taxes (gross income and wages), the money she actually receives will likely not cover her unreimbursed costs. This result can be avoided by not allowing an employee to pay premiums with pre-tax dollars.
Also, as discussed in our previous post, benefit programs can be subject to ERISA if the employer fails to meet the stringent requirements of the voluntary plan safe harbor. Allowing employees to pay premiums on a pre-tax basis through a Cafeteria/Section 125 plan is a sure fire way to fail the voluntary plan safe harbor test making your fixed indemnity plan an employer sponsored plan subject to ERISA. Some of the consequences of having your plan subject to ERISA are discussed in our previous post on “voluntary” benefit plans.