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What Are the Benefits of a Section 125 Plan?

Section 125 plans offer employees significant tax savings and could be an appealing part of any benefits package.

MIranda Fraraccio
Written by: Miranda Fraraccio, Senior WriterUpdated Apr 29, 2025
Shari Weiss,Senior Editor
Business.com earns commissions from some listed providers. Editorial Guidelines.
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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. 

What is a Section 125 plan (cafeteria plan)?

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.

How does a Section 125 plan work?

Section 125 plans are very straightforward: 

  • An employer sets aside a portion of an employee’s pretax wages to cover the costs of the plan’s qualified benefits, such as health care. 
  • The employee never receives this money as part of their standard wages, so federal income tax is not deducted from these earnings. 

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.

TipBottom line
The best HR software providers also offer tools for starting and managing Section 125 plans.

Section 125 plan pros and cons

Section 125 plans have upsides and downsides for employees and employers.

Pros

Both employers and employees can reap the following benefits from Section 125 plans:

  • Employees pay less in taxes: Employees pay less in taxes because the money allocated toward their Section 125 plans isn’t taxed as standard 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 salary instead, they would lose a portion of it (often a percentage in the double digits) to taxes.
  • Employers pay less in taxes: Employers benefit from setting aside wages for Section 125 use, since employer payroll taxes collected through the Federal Insurance Contributions Act (FICA) and the Federal Unemployment Tax Act are not taken on these funds. “Offering a Section 125 cafeteria plan could provide businesses a competitive edge by offering their employees benefits while also reducing payroll taxes,” explained Brittany Truszkowski, SHRM-SCP and chief operating officer of Grand Canyon Law Group.

Cons

However, there are also some drawbacks to consider with Section 125 plans:

  • Section 125 plans have setup fees: Setting up Section 125 plans comes at a cost. 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 them enough money to balance out setup fees.
  • Section 125 plan 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 money that could have been part of a paycheck goes unused, the employee may end up worse off financially than if they had simply kept the full paycheck instead. 
  • Section 125 funds are reimbursed: Section 125 qualified benefits often take the form of flexible spending arrangements, such as a dependent care FSA. This means employees must pay for their qualified expenses and then await reimbursement. “Most Section 125 plans work on a reimbursement model instead of direct payments, which means more paperwork and more headaches for everyone,” Cohen noted.
Did You Know?Did you know
Section 125 plans reduce an employee's taxable salary, so businesses will pay less in payroll taxes, FICA taxes, unemployment insurance and workers' compensation.

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, 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.

What does a Section 125 plan cover?

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:

  • Accident and health benefits: This supplemental health coverage policy covers employee medical expenses for transportation to hospitals and lost income from not working during injury recovery periods. (Archer medical savings accounts and long-term care insurance are excluded.)
  • Dependent care assistance plans (DCAPs): Dependent care FSAs help 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 may also qualify if they have physical or mental disabilities requiring supervision and are 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 standard employer-provided life insurance. Under a cafeteria plan, employers take out policies and offer life insurance coverage as part of the benefits package.
  • Health savings accounts (HSAs): Through HSAs, employees can cover qualified medical expenses using the pretax dollars set aside in a Section 125 plan. These expenses include deductibles, co-insurance, co-payments and more, though usually not insurance premiums. Note that only employees with high-deductible health plans can contribute to HSAs. HSAs are not the same as Section 125 FSAs. “The Section 125 plan can be used to pay for eligible health care expenses during that calendar year, including insurance premiums and deductibles,” Truszkowski explained. “HSA does not have the ‘use it or lose it’ rule and can be used as a pretax way to pay for future medical expenses.”

Note the following additional considerations:

  • 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.
  • Generally, cafeteria plans can’t be used to fund health reimbursement arrangements (HRAs) as HRAs are employer-funded. However, if your company offers an Individual Coverage HRA (ICHRA), employees who purchase individual health insurance outside of a federal or state exchange (such as from a private insurer) may use cafeteria plan salary reductions to pay for their insurance premiums on a pretax basis. Cafeteria plans can also work alongside HRAs in other ways, such as funding FSAs for additional medical expenses.
FYIDid you know
The best PEO services can handle the implementation and management of FSAs, HSAs and HRAs while also offering medical, dental, vision, life and short- and long-term disability insurance.

How to start a Section 125 plan

Creating a Section 125 plan requires three relatively straightforward steps:

  1. Complete the required plan documentation.
  2. Notify employees that you are offering a cafeteria plan.
  3. Hire a third party to administer your Section 125 plan, manage documentation requirements, process employee reimbursements and keep your company updated on proposed regulations. 

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:

  • Eligibility to participate: If your third-party administrator 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 compensation levels equally.
  • Nontaxable benefits value: The value of nontaxable benefits provided to your key employees, whom your third-party administrator can help you identify, must be no more than 25 percent of the total value of all employees’ nontaxable benefits.

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.

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MIranda Fraraccio
Written by: Miranda Fraraccio, Senior Writer
Miranda Fraraccio is a writer with bylines on several B2B publications. She got her start working in different sectors of the music industry, before transitioning to focus on other creative projects, including writing, audio production, and creating visual content.
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