04 Mar Section 125 Plan Rules: What Employers & Employees Need to Know
Section 125 Plan Rules
A Section 125 plan, also known as a cafeteria plan, allows employees to pay for certain benefits pre-tax, reducing taxable income and increasing take-home pay. However, to take full advantage of these tax benefits, both employers and employees must follow IRS regulations and guidelines. In this guide, we break down the key rules, eligibility requirements, and common mistakes to avoid when implementing or participating in a Section 125 plan.
What Is a Section 125 Plan?
A Section 125 plan enables employees to contribute a portion of their salary toward qualified benefits before taxes are deducted. This reduces both federal income tax and FICA taxes, leading to significant savings for both employees and employers. Common benefits that qualify under Section 125 include:
- Health insurance premiums
- Flexible Spending Accounts (FSAs)
- Health Savings Accounts (HSAs)
- Dependent Care Assistance Plans (DCAPs)
- Group-term life insurance (up to $50,000)
Who Is Eligible for a Section 125 Plan?
Employers of any size can establish a Section 125 plan, but there are specific eligibility rules:
- Employers: Any business entity (corporations, partnerships, sole proprietors, LLCs) can offer a Section 125 plan.
- Employees: Full-time and part-time employees are eligible, but self-employed individuals, partners, and more-than-2% S-corp shareholders cannot participate in pre-tax benefits.
IRS Compliance Requirements
To maintain compliance with IRS regulations, Section 125 plans must adhere to these key rules:
Written Plan Document
The IRS requires employers to create a formal written plan document that outlines:
- The benefits offered
- Eligibility criteria
- Employee contribution rules
- Plan year details
Nondiscrimination Testing (NDT)
To prevent unfair tax advantages, employers must conduct annual nondiscrimination testing to ensure the plan does not favor highly compensated employees (HCEs) or key employees. The three main tests are:
- Eligibility Test – Ensures broad employee participation.
- Benefits and Contributions Test – Confirms benefits are provided fairly.
- Key Employee Concentration Test – Limits benefits for key employees to 25% of the total.
Plan Year and Mid-Year Election Changes
Employees generally cannot make changes to their Section 125 elections mid-year unless they experience a Qualifying Life Event (QLE), such as:
- Marriage or divorce
- Birth or adoption of a child
- Change in employment status
- Significant cost changes to benefits
Common Pitfalls to Avoid
Failing to Maintain a Written Plan
Without a formal plan document, an employer’s Section 125 plan is not IRS-compliant and may be subject to penalties.
Not Conducting Nondiscrimination Testing
Skipping annual compliance tests can result in penalties and taxation of pre-tax benefits for highly compensated employees.
Allowing Mid-Year Changes Without a QLE
Employees cannot change their elections outside of open enrollment unless they meet QLE criteria.
Misclassifying Employees
Employers must ensure they correctly identify eligible employees. Business owners and certain shareholders cannot participate in pre-tax benefits.
How The Policy Shop Can Help
Navigating Section 125 rules can be complex, but The Policy Shop makes it easy. We help businesses design compliant Section 125 plans that maximize tax savings and employee benefits.
Get Started Today
Want to ensure your Section 125 plan is fully compliant and optimized for savings? Contact The Policy Shop today to get expert guidance and a customized benefits strategy!