What Is a Section 125 Premium Only Plan?

A Section 125 Premium Only Plan (POP) is a type of benefit arrangement permitted under Section 125 of the Internal Revenue Code. It allows employees to pay their share of employer-sponsored insurance premiums with pre-tax dollars, which can lead to tax savings for both the employee and the employer. As a fundamental component of a cafeteria plan, its primary function is to enable participants to reduce their taxable income by redirecting a portion of their salary to cover qualified benefit costs.

Understanding the Premium Only Plan

A Premium Only Plan operates by allowing employees to elect a portion of their gross salary to be deducted before any taxes are calculated. This pre-tax deduction is then used to pay for their share of qualified insurance premiums. By reducing an employee’s gross taxable income, the plan directly lowers the amount subject to federal income tax, as well as Social Security (FICA) and Medicare taxes.

When premiums are paid pre-tax, these deductions are exempt from the 7.65% FICA payroll taxes. This mechanism applies not only to federal taxes but also to state income taxes where applicable, resulting in a lower overall tax burden for the employee.

Employees make annual elections for their premium deductions. This structure provides a significant tax advantage by allowing employees to pay for benefits with money that has not yet been taxed.

Eligible Expenses

A Premium Only Plan typically covers a defined set of employer-sponsored insurance premiums that qualify for pre-tax treatment under IRS guidelines. Commonly included premiums are those for health insurance, encompassing medical, dental, and vision coverage. These are among the most frequently utilized benefits within a POP, allowing employees to reduce the cost of essential healthcare.

The plan may also include premiums for group term life insurance, specifically for coverage up to $50,000. Additionally, employee-paid disability insurance premiums can be included on a pre-tax basis, offering another avenue for tax savings on income protection.

Advantages for Employers and Employees

Premium Only Plans offer financial benefits for both the workforce and the organization. Employees experience direct financial savings because their taxable income is reduced, leading to lower federal, state (where applicable), FICA, and Medicare taxes. This pre-tax payment approach translates into increased take-home pay compared to paying for the same premiums with after-tax dollars.

For employers, a POP generates significant payroll tax savings, notably on FICA and Federal Unemployment Tax Act (FUTA) liabilities. Because employee contributions are deducted before taxes, the employer’s total taxable payroll is reduced, leading to lower corresponding employer contributions for these taxes. For every dollar employees contribute pre-tax, employers typically save 7.65% in FICA taxes.

Beyond tax advantages, POPs are relatively simple to administer. Offering such a plan enhances the overall employee benefits package, which can improve employee morale and assist in attracting and retaining talent. This enhances the compensation package, making it more competitive and appealing.

Establishing and Maintaining the Plan

Employers must establish and maintain a Premium Only Plan in accordance with Internal Revenue Service (IRS) regulations. A formal, written plan document is a legal requirement for any Section 125 cafeteria plan. This document outlines the plan’s rules, eligibility, benefits, and election procedures.

Employees are generally required to make their benefit elections annually, typically before the start of the plan year, or during specific qualifying life events such as marriage, birth, or loss of other coverage. These elections are usually prospective, meaning they apply to future periods and cannot be made retroactively. Employers must clearly communicate the plan’s details, benefits, and the election process to all eligible employees.

POPs must also comply with IRS non-discrimination rules to ensure they do not disproportionately favor highly compensated employees (HCEs) or key employees. These rules involve specific tests. If a plan fails these non-discrimination tests, HCEs may lose the tax-exempt status of their benefits, resulting in those benefits being included in their gross income.

Accurate record-keeping of employee elections and deductions is necessary for ongoing compliance. Maintaining meticulous records supports the plan’s integrity and adherence to regulatory standards.