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What Are the Benefits of a Section 125 Plan?

Max Freedman
Max Freedman Contributing Writer
Updated Jan 23, 2023

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

While there are lots of benefits you can include in employee packages, one that is often overlooked is a Section 125 plan, also known as a cafeteria plan. Before you put together your benefits package, it is best to have a clear understanding of what these plans are, why they might 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 salary, into nontaxable benefits. Employees enrolled in Section 125 plans have their employer reserve part of their pretax cash earnings that they can then use 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 paycheck to be used for qualifying medical expenses. The benefit of setting this money aside is that employees can save up to 30% on local, state and federal taxes.

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

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. As such, the employee never receives this money as part of their standard wages, so federal income tax is not taken on these earnings. Employers benefit from setting aside wages for Section 125 use as well, since employer Federal Insurance Contributions Act (FICA) and Federal Unemployment Tax Act (FUTA) taxes are not taken on these funds.

Although taxes are not levied on these wages, you must still 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 in your cafeteria plan, you are responsible for managing it. However, you can seek assistance from accountants and other tax experts.

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 spent at least 1,000 hours working for your company in the previous calendar year qualify for your current plan year. 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 employees 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). This benefit 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. People 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 is the term for 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 life insurance plans as benefits to your employees 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.

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.

Section 125 plan pros and cons

Here are some of the benefits of Section 125 plans:

  • Employees pay less in taxes. Because the money you funnel from employees’ salaries toward their Section 125 plans isn’t taxed as normal income, they’ll pay less in taxes.
  • 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 qualified benefits. If you paid them this money as wages, they’d lose some of this money – often a percentage in the double digits – to taxes. This means they’d have less cash to spend on the out-of-pocket expenses that cafeteria plans cover.
  • 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 more money in your bank – an average of $115 per Section 125 plan participant, according to Investopedia.

Here are some of the drawbacks of Section 125 plans:

  • There are setup fees. There is a cost for setting up these plans. In the short term, you might worry that cafeteria plans’ setup fees are too high to justify starting a plan. If your company’s cash flow is on the lower side, perhaps this fee will indeed place too large a burden on your operations. 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 in to a Section 125 plan must use the money they’ve invested during the plan year; any 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 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. As explained earlier, Section 125 qualified benefits often take the shape of flexible spending arrangements. As such, 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.

How to start a Section 125 plan

Starting 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 conduct nondiscrimination testing. 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 contribution. Similarly, the benefits and contributions you offer in your Section 125 plan must equally favor employees of all compensations.
  • Concentration. The value of nontaxable benefits provided to your key employees – whom your third party can help you identify – must be at most 25% of the value of all employees’ nontaxable benefits.

If your company lapses on meeting these requirements, employees whom your Section 125 structure favors may lose favorable tax treatment. However, participants whom your plan does not favor will not lose tax benefits. Even when your Section 125 plan is accidentally discriminatory, it includes remedies for the disadvantaged parties.

Image Credit: Pinkypills / Getty Images
Max Freedman
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.