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Updated Feb 02, 2024

What Are the Benefits of a Section 125 Plan?

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Max Freedman, Contributing Writer

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Offering a great benefits package for employees helps businesses retain talent. But how can business owners save money when employer health insurance costs are soaring? One option that employers often overlook is a Section 125 plan (sometimes known as a “cafeteria plan”). Before you put together your benefits package, you should understand the definition of a Section 125 plan, when it can benefit your company and how you can start one.

What is a Section 125 plan (cafeteria plan)?

A Section 125 plan allows employees to convert their taxable benefits, such as their salaries, into nontaxable benefits. Employees enrolled in Section 125 plans can reserve part of their pretax cash earnings to cover the costs of qualified benefits. A common example of a Section 125 plan is a flexible spending account (FSA), in which employees set aside pretax dollars from their paychecks to be used for qualifying medical expenses. The benefit of setting this money aside is that employees can save up to 30 percent on local, state and federal taxes.

As with most employee benefit plans, there is no obligation to participate in a Section 125 plan. Some employees may forego Section 125 plans in favor of standard cash wages. However, for many employees, setting aside money before taxes are taken out is preferable.

How does a Section 125 plan work?

In a Section 125 plan, an employer sets aside a portion of an employee’s pretax wages to cover the costs of the plan’s qualified benefits. The employee never receives this money as part of their standard wages, so federal income tax is not taken on these earnings. Employers also benefit from setting aside wages for Section 125 use, since employer payroll taxes collected through Federal Insurance Contributions Act (FICA) and Federal Unemployment Tax Act (FUTA) are not taken on these funds.

Although taxes are not levied on these wages, you still must report them on your employees’ W-2 forms. For example, if you set aside $1,000 of an employee’s salary toward a Section 125 benefit during a plan year, you must report that amount on Box 10 of the employee’s Form W-2.

No matter the benefits you offer, you are responsible for managing the Section 125 plan. A professional employer organization (PEO) can help you perform these human resources (HR)-related tasks and administer benefits plans. The best HR software providers also offer tools for starting and managing Section 125 plans. 

FYIDid you know

A PEO is a third-party organization that assumes co-liability for your workforce.

Section 125 plan pros and cons

Here are some of the benefits of Section 125 plans:

  • Employees pay less in taxes: Employees will pay less in taxes because the money you funnel toward their Section 125 plans isn’t taxed as normal income.
  • Employees have more money for out-of-pocket expenses: If you put $5,000 aside for an employee’s Section 125 plan, that’s a tax-free $5,000 they can use to cover out-of-pocket expenses. If you paid out this sum as part of their regular salaries instead, they would lose some of this money (often a percentage in the double digits) to taxes.
  • Employers pay less in taxes too: Your company doesn’t have to pay FICA or FUTA taxes on employee wages set aside for Section 125 purposes. That means that you can reduce your business’s tax liability. 

Here are some of the drawbacks of Section 125 plans:

  • There are setup fees: There is a cost for setting up Section 125 plans. In the short term, startups or businesses with cash flow problems might worry that setup fees are too high to justify starting a plan. However, in the long run, Section 125 employer tax savings can save you enough money to balance out your setup fees.
  • Funds expire: Employees who opt into a Section 125 plan must use the money they’ve invested during the plan year; unused money does not roll over to the next plan year. This introduces some risk to Section 125 plans. If the money that could have been part of a paycheck goes unused as part of the Section 125 plan, the employee may be worse off financially than without their Section 125 plan.
  • Section 125 funds are reimbursed, not used directly: Section 125 qualified benefits often take the shape of flexible spending arrangements. This means that employees must pay for their qualified benefits and then await reimbursement from their cafeteria plans. For some employees, this structure may result in challenges in acquiring the services they desire in the first place.
Did You Know?Did you know

You don’t need to pay FICA or FUTA taxes on the portion of employee wages set aside for Section 125 plans.

Who can open a Section 125 plan?

All types of employers can open a Section 125 plan, including C corporations, S corporations, partnerships, limited liability companies and sole proprietors. Government entities can also offer these types of benefits to employees.

You should also know who on your team qualifies for cafeteria plan coverage. Typically, all employees who worked at least 1,000 hours for your company in the previous calendar year qualify for your current plan year. This difference may influence your decision to hire full-time or part-time employees. That said, you can exclude two employee groups from your coverage: employees under 21 and those who have worked for your company for less than a year.

What does a Section 125 plan cover?

No matter which benefits you choose to include in your plan, you must specify in writing what your Section 125 plan encompasses, how employees can qualify for these programs and how they can choose the benefits that are right for them. According to Section 125 of the Internal Revenue Code, cafeteria plans can cover the following qualified benefits:

  • Accident and health benefits: Exclusions are Archer medical savings accounts and long-term-care insurance. This supplemental health coverage policy deals with employee medical expenses for transportation to hospitals and income lost from not working during injury recovery periods.
  • Dependent care assistance plans (DCAPs): A dependent care flexible spending account helps cover the cost of care for qualifying dependents. The IRS defines qualifying dependents as all children 12 and under who live with the employee. Those aged 13 or older also qualify if their physical or mental disabilities require the employee’s supervision and the person is regularly present in the employee’s household for at least eight hours per day.
  • Adoption assistance: An adoption assistance plan partially or fully covers employee expenses for child adoption. These plans typically include paid or unpaid leave for employees who have recently adopted children. Information and referral services may also be covered.
  • Group-term life insurance: Group-term insurance refers to the standard employer-based health insurance model but, in the case of cafeteria plans, this model is used for life insurance, not healthcare. As an employer, you will take out a policy and sign a contract with a life insurance provider. You can then offer your employees life insurance plans as benefits through your cafeteria plan.
  • Health savings accounts (HSAs), including those that cover long-term-care services: Through HSAs, your employees can cover their qualified medical expenses using the pretax dollars you set aside in your Section 125 plan. These expenses include insurance deductibles, co-insurance, co-payments and more, though usually not insurance premiums. Note that only employees who have high-deductible health plans can contribute to HSAs.
TipBottom line

Adoption assistance benefits, HSAs and DCAPs are traditionally offered as FSAs that reimburse employees for their qualified benefit expenses. FSAs typically include annual maximums and stipulate that funds don’t carry over from one plan year to the next.

Additionally, one exception exists regarding HSA coverage through cafeteria plans. This exception applies if your company offers health reimbursement arrangements (HRAs) through which your company covers your employees’ qualified medical expenses or insurance premiums. If this is the case and your employee has obtained insurance outside federal or state health insurance marketplaces or exchanges, the employee can use their cafeteria plan set-asides to cover non-HRA medical expenses and insurance premiums. This is the only case in which cafeteria plans can include HRAs.

How to start a Section 125 plan

Creating a Section 125 plan requires three fairly simple steps:

  1. Complete the required plan documentation.
  2. Notify employees that you are offering cafeteria plans.
  3. To meet your documentation needs, hire a third party to administer your Section 125 plan, process employee reimbursements and keep your company abreast of proposed regulations.

Once you begin offering Section 125 plans, you must remain vigilant about employment and anti-discrimination laws. Your company’s Section 125 plan must pass these three nondiscrimination tests:

  • Eligibility to participate: If your third-party Section 125 company finds that your plan makes it easier for your company’s highest-paid employees to participate, you must revise your plan.
  • Benefits and contributions: Similarly, the benefits and contributions you offer in your Section 125 plan must favor employees of all compensations equally.
  • The value of nontaxable benefits provided to your key employees ― whom your third party can help you identify ― must be at most 25 percent of the value of all employees’ nontaxable benefits.

Employees may lose favorable tax treatment if your company lapses in meeting these requirements. Even when your Section 125 plan is accidentally discriminatory, it includes remedies for the disadvantaged parties.

Mike Berner contributed to this article.

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Max Freedman, Contributing Writer
Max Freedman is a content writer who has written hundreds of articles about small business strategy and operations, with a focus on finance and HR topics. He's also published articles on payroll, small business funding, and content marketing. In addition to covering these business fundamentals, Max also writes about improving company culture, optimizing business social media pages, and choosing appropriate organizational structures for small businesses.
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