What Is a Section 125 Plan and How Does It Work?

A Section 125 plan, often referred to as a “cafeteria plan,” offers a valuable way for employees to manage their finances related to benefit expenses. This type of plan, governed by Internal Revenue Code Section 125, allows individuals to choose between receiving taxable cash compensation or certain qualified benefits on a pre-tax basis. This article explains Section 125 plans, their benefits, and how to participate.

Understanding Section 125 Plans

A Section 125 plan is an employer-sponsored benefit program that permits employees to pay for certain benefits using pre-tax dollars. Often called a “cafeteria plan,” employees select from a menu of benefits. Money allocated to these benefits is deducted from an employee’s gross pay before federal, state, and Social Security and Medicare (FICA) taxes are calculated.

This pre-tax deduction significantly reduces an employee’s taxable income, leading to a higher take-home pay compared to paying for the same benefits with after-tax dollars. For example, if an employee is in a 25% combined tax bracket and contributes $100 to a Section 125 plan, their taxable income decreases by $100, resulting in a tax saving of $25.

Employers also realize substantial tax advantages by offering Section 125 plans. Since employee contributions are made on a pre-tax basis, these amounts are not subject to the employer’s portion of FICA taxes. This includes Social Security tax, which is 6.2% on wages up to an annual limit, and Medicare tax, which is 1.45% on all wages.

Additionally, employers can reduce their Federal Unemployment Tax Act (FUTA) liability, which is generally 6.0% on the first $7,000 of an employee’s wages, though most employers receive a credit that reduces this rate to 0.6%. The reduction in payroll taxes for employers can be considerable, especially for businesses with many participating employees.

A Section 125 plan provides employees a choice between taxable cash and non-taxable qualified benefits, which is crucial for IRS qualification. Employers must establish a written plan document outlining the benefits offered, eligibility rules, and contribution limits.

The pre-tax deductions are typically noted on an employee’s pay stub, clearly separating these amounts from taxable wages. This reduces the income reported in Box 1 of Form W-2 at the end of the year, reflecting the tax savings achieved.

Types of Benefits in a Section 125 Plan

Section 125 plans can incorporate various qualified benefits. One of the most common applications involves health insurance premiums. Employees can pay their share of group health, dental, and vision insurance premiums with pre-tax dollars.

Flexible Spending Accounts (FSAs) are a prominent feature within many Section 125 plans. A Health FSA covers eligible medical, dental, and vision expenses, including co-pays, deductibles, and prescriptions. For 2025, the IRS limits employee contributions to a Health FSA to $3,300 per year.

Health FSAs typically operate under a “use-it-or-lose-it” rule, meaning any unused funds at the end of the plan year are generally forfeited. However, some plans may offer a grace period of up to 2.5 months into the next plan year to incur expenses or allow a limited carryover of unused funds. For 2025, the maximum carryover amount for a Health FSA is $660 into the 2026 plan year, if the plan design permits.

A Dependent Care FSA helps cover expenses for the care of qualifying dependents, such as children under age 13 or disabled spouses/dependents, to allow the employee and spouse to work or look for work. Common eligible expenses include daycare, after-school programs, and elder care. The annual contribution limit for a Dependent Care FSA for 2025 is $5,000 for individuals or married couples filing jointly, or $2,500 if married filing separately.

Similar to Health FSAs, Dependent Care FSAs also typically follow the “use-it-or-lose-it” rule, with a grace period of up to 2.5 months sometimes offered.

Health Savings Accounts (HSAs) can also be funded through pre-tax payroll deductions via a Section 125 plan, provided the employee is enrolled in a high-deductible health plan (HDHP). HSA contributions are tax-deductible, grow tax-free, and qualified withdrawals for medical expenses are tax-free. For 2025, the maximum HSA contribution is $4,300 for self-only coverage and $8,550 for family coverage, with an additional $1,000 catch-up contribution for those age 55 and older.

Unlike FSAs, HSAs are not subject to the “use-it-or-lose-it” rule; the funds roll over year to year and are portable, meaning they belong to the employee even if they change jobs. Other qualified benefits sometimes included in Section 125 plans are accident and disability coverage, adoption assistance, and group-term life insurance up to $50,000.

Navigating Your Section 125 Plan

Employees make benefit selections during an annual open enrollment period, which typically occurs before the start of the new plan year. Once elections are made, they are usually irrevocable for the duration of the plan year.

However, the Internal Revenue Service (IRS) allows exceptions to this rule for certain “Qualifying Life Events” (QLEs). These events permit employees to make mid-year changes to their benefit elections outside of the standard open enrollment period.

Examples of common QLEs include changes in legal marital status, such as marriage, divorce, or legal separation. A change in the number of dependents, due to events like the birth or adoption of a child, also qualifies. Significant changes in employment status for the employee, spouse, or dependent, such as starting or terminating employment, can also trigger a QLE.

Other QLEs may include a dependent gaining or losing eligibility for coverage due to reaching a certain age, or a change in residence that affects benefit eligibility. When a QLE occurs, employees typically have a limited timeframe to request a change to their benefit elections.

A crucial aspect of making changes due to a QLE is the “consistency rule.” This rule dictates that any change in benefit election must be consistent with the nature of the qualifying event.

Employers outline these specific QLEs and the corresponding permissible changes in their Section 125 plan documents. Employees should review these documents or consult with their human resources department to understand the specific rules and timeframes applicable to their plan.