A Section 125 plan, also known as a cafeteria plan, allows employees to pay for qualified benefits with pre-tax dollars, reducing taxable income for both employees and employers. This IRS-approved benefit program helps businesses attract top talent, save on payroll taxes, and offer competitive benefits packages.
At Summit Health Benefits, we help small and mid-sized businesses implement Section 125 plans that deliver measurable tax savings and improve employee satisfaction.
Key Takeaways
- Employees save 25–40% on benefit costs through pre-tax contributions
- Employers save 7.65% on FICA taxes for every employee contribution
- Three main types of plans: Premium Only Plans (POP), FSAs, and Full Cafeteria Plans
- Section 125 plans are available for businesses of any size, including small businesses
- Helps attract and retain talent by offering flexible benefits
Table of Contents
- What Is a Section 125 Plan?
- How Does a Section 125 Plan Work?
- Types of Section 125 Plans
- Eligible Benefits Under Section 125
- Tax Advantages for Employers and Employees
- Who Can Participate?
- How to Set Up a Section 125 Plan
- Compliance Requirements
- Section 125 FAQs
What Is a Section 125 Plan?
A Section 125 cafeteria plan is an employer-sponsored benefit program that lets employees choose between receiving salary in cash or directing part of their pay toward qualified benefits on a pre-tax basis.
Because contributions are deducted before federal income tax, Social Security tax, and Medicare tax, both employers and employees enjoy significant savings.
Also known as a cafeteria plan (because employees can “pick and choose” benefits), Section 125 plans have become essential for businesses aiming to provide flexible, cost-effective benefits.
Example: An employer with 25 employees can save $8,000–$12,000 per year in payroll taxes with a Section 125 plan.
How Does a Section 125 Plan Work?
Section 125 plans operate in four simple steps:
- Employee Election: Employees select benefits and contribution amounts before the plan year begins.
- Salary Reduction: Contributions are deducted from gross salary before taxes.
- Pre-Tax Benefits: Contributions are exempt from federal, state, and Social Security taxes.
- Benefit Payment: Pre-tax dollars are applied toward selected benefits.
Example: If an employee earns $50,000 and contributes $6,000 to health insurance through a Section 125 plan, taxable income drops to $44,000, saving roughly $1,500–$2,400 in taxes.
Types of Section 125 Plans
There are three main types of Section 125 plans, each with specific use cases:
1. Premium Only Plan (POP)
- Simplest and most common
- Covers health, dental, vision, life, and disability premiums
- Low-cost implementation and easy administration
2. Flexible Spending Account (FSA)
- Health FSA: Covers medical, dental, and vision out-of-pocket costs
- Dependent Care FSA: Covers childcare or eldercare expenses
- Limited Purpose FSA: Works alongside an HSA for dental and vision only
3. Full Cafeteria Plan
- Combines POP, FSA, and additional benefits
- Employees receive flex credits to allocate according to needs
Eligible Benefits Under Section 125
Qualified benefits under Section 125 include:
- Health insurance premiums (medical, dental, vision)
- Health Savings Account (HSA) contributions
- Flexible Spending Accounts (Health FSA, Dependent Care FSA)
- Accident and disability insurance premiums
- Group-term life insurance (up to $50,000)
- Adoption assistance
Not eligible:
- Archer MSAs
- Long-term care insurance
- Educational assistance
- Qualified transportation benefits (separate tax programs)
Tax Advantages for Employers and Employees
For Employees:
- Contributions exempt from federal income tax (12–37%)
- Exempt from Social Security (6.2%) and Medicare (1.45%)
- In most states, also exempt from state income tax
- Typical savings: 25–40% of contributions
For Employers:
- Save 7.65% on FICA for all contributions
- Lower workers’ compensation premiums
- Reduced unemployment insurance costs
- No additional cost beyond plan administration
Example: $100,000 in contributions saves $7,650 in payroll taxes.
Who Can Participate?
Eligible participants:
- W-2 employees of the sponsoring employer
- Spouses and dependents for benefit coverage
Not eligible:
- Self-employed individuals
- Partners in a partnership
- More than 2% S-Corp shareholders
- Independent contractors (1099 workers)
Note: C-Corp shareholders who are employees can fully participate.
How to Set Up a Section 125 Plan
Steps to implement a Section 125 plan:
- Draft a Plan Document: Outlines rules, benefits, and administration procedures
- Create a Summary Plan Description (SPD): Simplified version for employees
- Establish Election Procedures: Employees make benefit elections
- Update Payroll Systems: Handle pre-tax deductions correctly
- Communicate to Employees: Educate staff on benefits and tax savings
At Summit Health Benefits, we handle all steps for seamless implementation and IRS compliance.
Compliance Requirements
Section 125 plans must meet specific IRS requirements to maintain their tax-advantaged status:
- Written Plan Document: Must be in writing and maintained by the employer
- Non-Discrimination Testing: Plans must not discriminate in favor of highly compensated employees
- Irrevocable Elections: Employees generally cannot change their elections mid-year except for qualifying life events
- Use-It-or-Lose-It Rule: FSA funds not used by the plan deadline may be forfeited (with some exceptions)
- Proper Documentation: Employers must maintain records of plan operations
Non-compliance can lead to lost tax benefits and penalties. Working with an experienced benefits administrator like Summit Health Benefits ensures your plan stays compliant year after year.
Ready to Reduce Your Healthcare Costs?
Get a free consultation with our Section 125 experts. We'll show you how much you can save.
Learn more about Section 125 plans or get your free consultation.