Section 125 Plan: Guide for Employers & Employees

If you’re an employer or employee looking for ways to maximize tax savings on benefits, a Section 125 plan might be exactly what you need. These plans allow employees to pay for eligible benefits pre-tax, reducing taxable income and increasing take-home pay. But how do Section 125 plans work, and why should businesses offer them? Let’s break it down.

What Is a Section 125 Plan?

A Section 125 plan—also called a cafeteria plan—is a tax-advantaged benefit plan authorized by the IRS under Section 125 of the Internal Revenue Code. It allows employees to contribute a portion of their salary toward certain benefits before taxes are deducted. This reduces both federal income tax and payroll taxes for employees and lowers payroll tax liabilities for employers.

What Benefits Can Be Included?

Section 125 plans can cover a variety of benefits, including:

• Health insurance premiums (medical, dental, vision)
• Flexible Spending Accounts (FSAs) for healthcare expenses
• Dependent Care FSAs for child or elder care costs
• Health Savings Accounts (HSAs)
• Group life insurance (up to $50,000 in coverage)

Why Do Section 125 Plans Matter?

For Employers:

✔ Tax Savings – Employers save on payroll taxes (FICA, FUTA, and SUTA) because employee contributions are made pre-tax.
✔ Employee Retention – Offering a cafeteria plan makes benefits more affordable and attractive to employees.
✔ Compliance-Friendly – Section 125 plans are recognized by the IRS and help employers provide competitive benefits while staying tax-compliant.

For Employees:

✔ Lower Taxable Income – Employees take home more of their earnings by reducing their taxable salary.
✔ Affordable Benefits – Pre-tax contributions make health, dental, and dependent care coverage more cost-effective.
✔ Increased Spending Power – More money stays in employees’ pockets for essential expenses.

How to Set Up a Section 125 Plan

Employers must follow specific IRS guidelines when setting up a Section 125 plan, including:

1. Create a Written Plan Document – The plan must be documented and available to employees.
2. Define Eligibility Requirements – Typically, full-time employees qualify, but employers can set additional criteria.
3. Ensure IRS Compliance – Plans must adhere to nondiscrimination rules to ensure fairness among employees.
4. Educate Employees – Employers should provide clear communication about the benefits and enrollment process.

Are There Any Restrictions?

• Employees must elect benefits before the plan year begins (with limited exceptions for qualifying life events).
• Funds in FSAs are “use it or lose it” unless a grace period or carryover option is offered.
• Employers must follow IRS nondiscrimination testing to ensure that highly compensated employees do not disproportionately benefit.

Is a Section 125 Plan Right for Your Business?

If you’re looking for a cost-effective way to offer better benefits while saving on taxes, a Section 125 plan is a smart choice. Employers benefit from lower payroll taxes, while employees enjoy increased take-home pay.

Ready to set up a Section 125 plan for your business? Contact The Policy Shop today to explore your options and get expert guidance on maximizing your tax benefits!