What Is a Premium Only Plan & How Does It Work?

A Premium Only Plan (POP) is a type of employee benefit plan that enables employees to pay their portion of certain employer-sponsored insurance premiums with pre-tax dollars. This arrangement primarily covers health, dental, and vision insurance premiums, though it can extend to other qualified benefits such as group term life insurance or disability insurance. The purpose of a POP is to allow both employees and employers to realize tax savings. This advantage stems from the fact that contributions are deducted from an employee’s gross pay before taxes are calculated.

How a Premium Only Plan Operates

Employee contributions for eligible insurance premiums are deducted from their gross pay. These deductions occur before the calculation of federal income tax, and where applicable, state income tax, as well as Federal Insurance Contributions Act (FICA) taxes, which include Social Security and Medicare taxes. This pre-tax treatment means that the employee’s taxable income is reduced by the amount of the premium deduction. Consequently, employees experience an increase in their take-home pay because less of their income is subject to taxation.

For instance, if an employee earns $2,500 bi-weekly and pays $200 for health insurance premiums, under a POP, their taxable income would be reduced to $2,300. This contrasts with an after-tax deduction, where taxes would be calculated on the full $2,500. Depending on an employee’s income level and tax bracket, this can result in tax savings ranging from approximately 25% to 40% on the premiums paid. Employers also benefit from a POP. The total payroll subject to FICA taxes is lowered because the employees’ pre-tax contributions reduce the overall taxable payroll.

This reduction in taxable payroll translates directly into savings for the employer on their matching FICA tax liability, typically 7.65% (6.2% for Social Security and 1.45% for Medicare) of the pre-taxed amount. Therefore, for every dollar an employee contributes pre-tax, the employer can save 7.65 cents in FICA taxes. Premium Only Plans are the most common and simplest form of a Section 125 “cafeteria plan,” governed by Internal Revenue Code Section 125, allowing employees to choose between taxable cash and certain tax-free benefits.

Steps to Establish a Premium Only Plan

Establishing a Premium Only Plan involves several preparatory steps to ensure its proper and compliant operation. The initial phase centers on the employer’s decision to offer a POP and to determine which types of eligible premiums, such as medical, dental, or vision, will be included. This decision helps shape the plan’s design to align with the organization’s benefits strategy.

A legally mandated component for any Section 125 plan, including a POP, is a formal, written plan document. This document serves as the blueprint for the plan, detailing essential elements such as eligibility rules for employees, the specific benefits covered, methods for employee contributions, and the designation of a plan administrator. The written plan document must clearly state the effective date of the plan, which is required to be in place before the first day of the plan year.

Following the drafting of the plan document, the employer must formally adopt the plan. This adoption occurs through a board resolution or a similar official internal company action, signifying the employer’s commitment to and implementation of the POP. After formal adoption, communication with employees is essential. Employers must inform eligible employees about the plan’s availability and its features.

An important aspect of employee communication involves providing a Summary Plan Description (SPD), which outlines the plan’s key provisions in an understandable format. Employees who choose to participate in the POP must then complete and sign a salary reduction agreement. This agreement authorizes the employer to deduct their elected premium contributions from their gross pay on a pre-tax basis, making their enrollment official.

Maintaining Plan Compliance

Once a Premium Only Plan is established and operational, ongoing compliance is essential to maintain its tax-advantaged status. A significant requirement involves adherence to Internal Revenue Service (IRS) non-discrimination rules. These rules are designed to ensure that the plan does not disproportionately favor highly compensated employees or key employees over other employees regarding eligibility, benefits, and contributions. The plan must be fair and accessible to all eligible employees.

Maintaining accurate records is another ongoing responsibility. Employers must keep detailed records of employee elections, the amounts of premium deductions, and all plan contributions. These records are important for verifying compliance and can be necessary in the event of an IRS audit.

Regarding reporting, POPs generally have fewer complex annual reporting forms compared to other types of Section 125 plans. For informational purposes, the value of employer-sponsored health coverage, which includes pre-tax premium deductions, is often reported in Box 12 of the employee’s Form W-2 with Code DD. This reporting is for information only and does not imply that the coverage amount is taxable income to the employee.

Periodically, employers may need to amend the plan document. This process is necessary if there are changes to the plan’s design, such as adding new eligible benefits, modifying eligibility rules, or updating administrative procedures. Any significant changes to the plan necessitate a formal amendment to the written plan document to ensure continued compliance with IRS regulations.