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Section 125 Plans

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What is a Section 125 Cafeteria Plan

A Section 125 Cafeteria Plan is an IRS-approved employee benefit plan that allows employees to pay for certain qualified benefits with pre-tax dollars. This means contributions for benefits like health insurance premiums, Flexible Spending Accounts (FSAs), and Dependent Care FSAs are deducted from gross income before federal, state, and FICA taxes are calculated, resulting in significant tax savings for the employee

With a Section 125 plan in place allowing employees to have pre-tax deductions to pay for their share of benefit costs, tax savings for employees and the employer are significant:

 

  • Participant tax savings: Any employee payroll deductions for eligible benefits are exempt from federal income tax, state income tax, and the employee’s share of FICA/Social Security taxes (7.65%).
  • Employer tax savings: Any employee payroll deductions are exempt from the employer’s FICA/Social Security match (7.65%).
  • Employee Benefits by paying less in taxes, which increases their take-home pay. They can also save money on health insurance, dependent care, and other eligible benefits.
  • Employers save on payroll taxes because pre-tax contributions lower the taxable income of employees. This helps reduce the business’s overall tax burden.

Section 125 Plans are ideal for small to mid-sized businesses looking to offer affordable benefits. They work especially well for:

 

  • Companies with W-2 employees
  • Businesses looking for cost-effective benefit solutions
  • Employers wanting to offer more benefits without increasing costs

Types of Benefits You Can Include:

Section 125 Plans are flexible and can include a wide variety of benefits, such as:

 

  • Health insurance premiums
  • Dental and Vision
  • Flexible Spending Accounts (FSAs)
  • Dependent Care Assistance Plans (DCAP)
  • Preventative Care Programs
  • Commuter and parking benefits
  • Health Savings Accounts (HSAs)
  • Premium Only Plans (POP)

 

These benefits help employees save on taxes and give businesses a competitive edge.

Employees select pre-tax benefit elections during open enrollment. These elections reduce their gross income, which in turn reduces the employer’s tax liability. Employers must maintain compliance with IRS rules and provide documentation like a plan document and Summary Plan Description (SPD).

If an employer sponsors a Section 125 plan, common-law employees may generally participate and utilize pre-tax deductions for benefits if they meet eligibility requirements set by the employer. Any eligible employee may also pay on a pre-tax basis for premiums or contributions toward coverage a legal spouse or qualifying dependent(s).

 

IRS rules do not allow non-employees to utilize tax-free benefits. Individuals who are contractors and receive 1099 income rather than W-2 income are not eligible. Similarly, an employee may not use pre-tax deductions to cover an individual who is not a legal spouse or qualifying dependent. Any coverage for a domestic partner is taxable.

 

Owners and family members of owners can only participate in limited circumstances. If the organization is a C-Corporation, owners are eligible to utilize tax-free benefits. However, if the organization is an S-Corp, LLC, Partnership, or Sole Proprietorship, an owner or family member cannot participate in Section 125. The reasoning behind this IRS rule is that since these entities are “pass-through” for purposes of income and deductions, the owners will receive applicable tax deductions on their personal returns already without the need to receive them as employees and as owners.

 

Traditional plans may involve post-tax contributions or limited pre-tax benefits. Section 125 plans specifically structure benefit payments to be pre-tax, offering higher tax savings and more control.

Yes, many small businesses with as few as 5 to 10 W-2 employees can set up a compliant Section 125 plan. These plans are scalable and customizable based on employer needs.

Pre-tax deductions work by reducing an employee’s taxable income. For example, if an employee earns $50,000 per year and contributes $5,000 toward a Section 125 Plan, their taxable income becomes $45,000. This means they pay less in income tax, and employers save on payroll taxes.

The term comes from the idea of a “menu” of benefit choices that employees can select from, much like choosing from items in a cafeteria. Each employee picks the combination of benefits that best suits their needs.

Setting up a Section 125 Plan is simple:

 

  1. Choose a provider that specializes in Section 125 Plans.
  2. Draft a plan document outlining the benefits.
  3. Enroll employees and integrate payroll deductions.
  4. Maintain compliance with IRS rules.

 

You can easily set it up in just a few steps, and our experts are here to help!

Yes, because contributions to Section 125 plans reduce an employee’s gross taxable income, they also reduce the amount of income subject to FICA taxes (Social Security and Medicare). While this results in immediate tax savings, it can also lead to a slightly lower lifetime Social Security benefit upon retirement, as those benefits are calculated based on earnings history subject to FICA taxes.

Consider contributing the maximum allowable to Flexible Spending Accounts (FSAs) if you anticipate eligible medical or dependent care expenses. For 2025, the health FSA limit is $3,200, offering significant tax savings.

Be mindful of the ‘use-it-or-lose-it’ rule for FSAs. While some plans offer a grace period or carryover, unused funds are typically forfeited. Plan your contributions carefully based on anticipated expenses.

A unique rule under Section 125 is that once an election is made at the start of a plan year (or new period of coverage for a new hire or individual gaining eligibility mid-year), the election is locked in and cannot be changed for the remainder of the plan year. A plan year is generally 12 months and coincides with the employer’s renewal of insurance benefits and annual open enrollment.

 

An exception to the annual election rule is if an employee experiences a mid-year Qualifying Event or HIPAA Special Enrollment event that is recognized by the rules as the basis for an election change. For a mid-year change to be allowed by the plan, two requirements must be met. First, the facts giving rise to the requested change must represent a formal Qualifying Event or HIPAA Special Enrollment opportunity. Second, the requested change must be consistent with the event (the “Consistency Rule”). If the change is allowable under the rules, the employee may make a change to the pre-tax election for benefits that applies from the point of the change forward through the remainder of the plan year.

 

NOTE: The election rule only applies to pre-tax elections under Section 125. If an employee is enrolled in any benefit for which a pre-tax election is not applicable – such as if a benefit is fully employer paid or is paid with a post-tax election such as a supplemental life benefit or disability coverage – an election change can be made without a Qualifying Event.

Since 125 plans involve significant tax savings to employees and employers, IRS rules include certain guidelines to ensure that benefits are available to employees on a non-discriminatory basis. Below is a summary of tests that may apply. Certain 125 plans are exempt from testing. These include plans that do not have any Highly Compensated Employees or Key Employees, or plans that meet the provisions of the “Simple Cafeteria Plan” guidance from the IRS. (In this context, “Simple” is not directly related to the name of this service.) Additional information is available on testing and testing exemptions.

 

If testing applies, there are three different non-discrimination analyses for Section 125 plans which include only pre-tax premiums and contributions but not Flexible Spending Accounts. Note: Unlike the formal testing done for retirement plans, what is required under Section 125 is not that the employer run these tests and submit the tests to an authoritative body. Instead, the rules are in place as guidelines so that if an employer’s plan were ever scrutinized/tested by the IRS, the plan would pass. No formal testing or reporting of testing to the IRS is required.

 

The first two tests address (1) eligibility to participate, and (2) contribution/benefits. Both categories can be handled by plan design. If an employer applies its eligibility standards and contributions equally to all full-time employees, then the plan will automatically pass those tests.

 

There is a third test that is based on plan utilization – specifically, measuring the amount of pre-tax benefits used by certain Key Employees relative to those elected by non-Key Employees. This is the Key Employee Concentration Test, commonly known as the “25% Test.” This test is not an issue for most plans but may be a factor for plans sponsored by small employers with a heavy concentration of pre-tax elections by owners, officers, and highly compensated individuals.

 

To confirm, even if testing is applicable to a particular plan, testing or analysis is not included in the Simple 125 service. Simple 125 is designed only to assist employers with the plan document requirement.

Having a formal Plan Document and SPD in place is the primary compliance requirement for Section 125 plans. Other rules and considerations apply, as referenced in this FAQ, but those items typically do not require active administration or monitoring by a third party. The key step for any employer to protect valuable tax savings created by the plan is to have a document in place that authorizes pre-tax deductions by eligible employees.


Legacy Tax & Resolution Service was established to provide an efficient and effective solution for employers and advisors. With the plan document in place, remaining responsibilities of the employer can be handled with education and advising.

Your benefit elections and tax situation can change. Re-evaluate your Section 125 plan choices during your employer’s open enrollment period each year to ensure you’re maximizing your savings for the current tax year.

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