What Are the Benefits of a Section 125 Plan?

What is a Section 125 plan (cafeteria plan)?

A Section 125 plan is an employer-sponsored benefits plan that allows employees to convert taxable compensation, such as part of their salary, into nontaxable benefits. Employees enrolled in a Section 125 plan can set aside a portion of their pretax 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 cover qualifying medical expenses. Because those contributions reduce taxable income, employees can see meaningful tax savings, depending on their federal, state, and local tax rates.

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 can be 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 Near.

How does a Section 125 plan work?

Section 125 plans are relatively 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 those 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 provider, 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 plan pros and cons

Section 125 plans offer benefits for both employees and employers, but they also come with trade-offs.

Pros

Both employers and employees can benefit from Section 125 plans:

• Employees pay less in taxes: Money allocated to a Section 125 plan is excluded from taxable income, which lowers employees’ federal (and often state and local) tax liability.
• Employees keep more money for qualified expenses: If an employee sets aside $5,000 through a Section 125 plan, they can use the full amount for eligible out-of-pocket expenses. If that same $5,000 were paid as regular wages, taxes would reduce the take-home amount.
• Employers pay less in payroll taxes: Employers do not pay their share of FICA taxes on wages redirected to Section 125 benefits, which can lower payroll taxes. Specifically, employers save the 7.65 percent FICA match on every dollar an employee contributes to qualifying benefits under the plan. “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 some drawbacks to consider with Section 125 plans:

• Section 125 plans have setup and administrative costs: Setting up and maintaining a Section 125 plan involves fees for plan documents, nondiscrimination testing and ongoing administration. For startups or businesses with cash flow problems, those upfront costs can feel hard to justify, although employer payroll tax savings can offset them over time.
• Section 125 funds can expire: Employees typically have to spend their Section 125 funds during the plan year, a rule commonly known as “use it or lose it.” Some plans now allow a limited carryover — up to $660 for 2025 and $680 for 2026 — so unused funds aren’t completely lost.
• Section 125 funds are typically reimbursed: Many Section 125 benefits, such as health and dependent care FSAs, operate on a reimbursement model. Employees usually pay for eligible expenses upfront and submit claims for reimbursement, which can add paperwork and delay access to funds. “Most Section 125 plans work on a reimbursement model instead of direct payments, which means more paperwork and more headaches for everyone,” Cohen noted.

Who can open a Section 125 plan?

Most 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 benefits to their employees.

You should also know who on your team qualifies for cafeteria plan coverage. In many cases, employees who worked at least 1,000 hours in the prior calendar year are eligible for the current plan year. This eligibility requirement can influence how you structure full-time and part-time employee roles.

Employers can exclude certain groups from participation, including employees under age 21 and those who have worked for the company for less than one year.

What does a Section 125 plan cover?

Employers must document in writing which benefits their Section 125 plan includes, who is eligible and how employees can select coverage.

“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 include the following qualified benefits:

• Accident and health benefits: These benefits typically include employer-sponsored medical, dental and vision coverage offered through group health plans. 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. Employees can set aside up to $5,000 per year (for single filers or married filing jointly). Qualifying dependents generally include children under age 13 and spouses or dependents who are physically or mentally incapable of self-care.
• Adoption assistance: Adoption assistance plans help cover eligible adoption-related expenses and may include paid or unpaid leave, information services and referrals.
• Group-term life insurance: Employers can offer group-term life insurance as part of a cafeteria plan, though coverage above $50,000 may be taxable.
• Health savings accounts (HSAs): Employees with high-deductible health plans can contribute pretax dollars to HSAs to pay for qualified medical expenses such as deductibles, copayments and coinsurance. For 2025, the contribution limits are $4,300 for individuals and $8,550 for family coverage. For 2026, the limits increase to $4,400 and $8,750. HSAs are not the same as health FSAs and do not have a “use it or lose it” rule.

Note the following additional considerations:

• Health FSAs and DCAPs typically reimburse employees for qualified expenses.
• While the IRS allows limited FSA carryovers, many plans still impose annual maximums and forfeiture rules for unused funds above the carryover limit.
• Cafeteria plans generally can’t fund employer-funded HRAs, but employees enrolled in Individual Coverage HRAs (ICHRAs) may use pretax salary reductions to pay for individual market premiums outside of federal or state exchanges.

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 plan is 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. Source interviews were conducted for a previous version of this article.