Business.com aims to help business owners make informed decisions to support and grow their companies. We research and recommend products and services suitable for various business types, investing thousands of hours each year in this process.
As a business, we need to generate revenue to sustain our content. We have financial relationships with some companies we cover, earning commissions when readers purchase from our partners or share information about their needs. These relationships do not dictate our advice and recommendations. Our editorial team independently evaluates and recommends products and services based on their research and expertise. Learn more about our process and partners here.
Section 125 plans offer employees significant tax savings and could be an appealing part of any benefits package.
Offering a great employee benefits package helps businesses retain talent and boost employee engagement. But how can business owners save money when employer health insurance costs are soaring? One often-overlooked option is a Section 125 plan, sometimes known as a “cafeteria plan.”
We’ll explain what a Section 125 plan is, detail how it works and share tips on starting one to help employers decide if this option is right for their team.
A Section 125 plan is an employer-sponsored benefits plan that 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 40 percent on local, state and federal taxes.
As with most employee benefit plans, participation in a Section 125 plan is optional. Some employees may opt out and simply receive their full taxable wages instead. However, for many employees, setting aside money before taxes are deducted is the more advantageous choice.
“Section 125 plans are a good way to help workers control health care costs, which have been outpacing inflation for decades, so they definitely provide value at a low cost to companies,” explained Hayden Cohen, CEO and co-founder of Hire with Near.
Section 125 plans are very straightforward:
Although taxes are not levied on these wages, employers must document them using the appropriate tax and payroll forms, including reporting them on their 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, that amount would reduce their taxable wages reported in Box 1 of Form W-2. Some employers also report Section 125 deductions for informational purposes in Box 14, although this is optional.
Employers can manage these plans themselves or work with outsourced professionals. Cohen recommends using a qualified specialist, such as a professional employer organization (PEO) or HR outsourcing organization, to ensure expert benefits management and administration.
“A third-party administrator… [will] be able to handle reimbursements and make sure you’re documenting everything you need to be in order to stay compliant,” Cohen explained.
Section 125 plans have upsides and downsides for employees and employers.
Both employers and employees can reap the following benefits from Section 125 plans:
However, there are also some drawbacks to consider with Section 125 plans:
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, employees who have worked at least 1,000 hours for your company in the previous calendar year qualify for your current plan year. This eligibility requirement 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 been employed for less than one year.
Employers must detail in writing what their Section 125 plan encompasses, how employees can qualify for these programs and how they can choose the right benefits for their needs.
“Section 125 plans are flexible in terms of what kinds of benefits are covered, but you do have to specify those benefits when you set up your company-wide plan,” Cohen advised. “Just because something like adoption assistance could be covered under Section 125 doesn’t mean that it will be unless you set it up.”
According to Section 125 of the Internal Revenue Code, cafeteria plans can cover the following qualified benefits:
Note the following additional considerations:
Creating a Section 125 plan requires three relatively straightforward steps:
Truszkowski recommends choosing a third party with an experienced benefits administrator familiar with Section 125 regulations. “Once you have established your plan, create thorough policies and procedures to train HR staff and ensure that continuing education is happening, especially with the ever-evolving IRS regulations year to year,” Truszkowski added.
After your Section 125 plans are in effect, you must remain vigilant about employment and anti-discrimination laws. Your company’s Section 125 plan must pass these three nondiscrimination tests:
Employees may lose favorable tax treatment if your company fails to meet these requirements. Even if your Section 125 plan is accidentally discriminatory, the plan must include remedies to correct the imbalance.
Max Freedman and Mike Berner contributed to this article.