How to Set Up a Section 125 Plan for Your Business

A Section 125 plan, often called a cafeteria plan, provides a structured framework for employers to offer certain benefits to their employees on a pre-tax basis. This arrangement allows employees to pay for qualified benefits using money deducted from their gross earnings, thereby reducing their taxable income. Establishing such a plan enhances an employee’s total compensation package while also offering tax advantages to the employer. These plans help businesses attract and retain talent by providing flexible and tax-efficient benefit options.

Designing Your Plan

Before formally establishing a Section 125 plan, employers must make several foundational decisions regarding its structure and the benefits it will offer. A common type of Section 125 plan is a Premium Only Plan (POP), which allows employees to pay their share of health insurance premiums for medical, dental, and vision coverage with pre-tax dollars. Beyond POPs, a comprehensive Section 125 plan can encompass a wider array of qualified benefits, including Health Flexible Spending Accounts (FSAs) for out-of-pocket medical expenses, Dependent Care Flexible Spending Accounts (DCFSAs) for childcare or adult dependent care costs, and Health Savings Accounts (HSAs) when integrated with a high-deductible health plan.

Employers determine which specific pre-tax benefits will be available under their plan, tailoring the offerings to meet employee needs and business objectives. Eligibility rules must be established, defining which employees can participate, such as full-time or part-time staff. The plan year, which dictates the start and end dates for benefit elections and usage, also requires careful consideration during this design phase. For certain benefits like FSAs and DCFSAs, the Internal Revenue Service (IRS) imposes annual contribution limits.

Funding decisions are also part of this preparatory stage, primarily revolving around how employee contributions will be collected, typically through salary reductions. These pre-tax deductions reduce an employee’s taxable income for federal income, Medicare, and Social Security taxes, and often state and local taxes as well. Employers also realize tax savings from reduced payroll tax liabilities, including the Federal Insurance Contributions Act (FICA) and Federal Unemployment Tax Act (FUTA) taxes. Many businesses opt to engage a Third-Party Administrator (TPA) to manage their Section 125 plan. When selecting a TPA, factors such as their experience, service offerings, and fee structure should be carefully evaluated to ensure they align with the business’s administrative capacity and budget.

Formalizing the Plan

Once the design elements of a Section 125 plan are finalized, the next step involves formalizing it through the creation of necessary legal documents and the establishment of enrollment procedures. A written plan document is legally required by the IRS and is foundational to a compliant Section 125 plan. This document outlines all the plan’s provisions, including eligibility criteria, the specific benefits offered, the effective date of the plan, and administrative procedures.

In addition to the master plan document, employers are required to provide employees with a Summary Plan Description (SPD). The SPD is a plain-language explanation of the plan, designed to inform participants about their rights and obligations. It typically includes details on how benefits are paid and claims procedures.

The employer then initiates the employee enrollment process, which typically occurs annually during an “open enrollment” period. During this time, employees make their benefit elections for the upcoming plan year, deciding which qualified benefits they wish to participate in and their contribution amounts. Generally, these elections are irrevocable for the entire plan year, unless a qualifying life event occurs, such as marriage, divorce, birth of a child, or a change in employment status. Effective communication is important throughout this formalization stage. Employers must clearly convey the plan details, eligibility requirements, and the enrollment process to all eligible employees.

Maintaining Compliance and Administration

After a Section 125 plan is established, ongoing compliance and effective administration are necessary to preserve its tax-advantaged status. One significant requirement is annual non-discrimination testing, mandated by the IRS to ensure the plan does not disproportionately favor highly compensated employees (HCEs) or key employees. These tests, which include eligibility, contributions and benefits, and key employee concentration tests, verify that benefits are offered equally and that HCEs do not receive a better benefit than other employees. Failing these tests can result in the loss of tax benefits for HCEs.

Accurate and thorough record-keeping is another ongoing responsibility. Employers must maintain meticulous records of employee elections, contributions, and claims, as well as all plan documents. These records are important for demonstrating compliance during potential IRS audits. For plans that include Flexible Spending Accounts (FSAs) or Dependent Care Flexible Spending Accounts (DCFSAs), claims adjudication is a continuous administrative task, involving reviewing and processing employee claims for reimbursement against their elected pre-tax funds.

Reporting requirements also extend to the W-2 forms for employees. While Section 125 plan deductions reduce an employee’s taxable wages, certain benefits, like Dependent Care Assistance Plan (DCAP) benefits, are reported in specific boxes on Form W-2. Plan documents require periodic amendments and updates to reflect changes in IRS regulations or modifications to the plan’s design. This ongoing review and adaptation maintain compliance.