What Is Section 125 of the Tax Code?

A Section 125 plan, more commonly known as a “cafeteria plan,” is an employer-sponsored benefit plan established by the Internal Revenue Code. It allows employees to choose from a menu of benefits and pay for them with pre-tax dollars. These funds are taken from an employee’s paycheck before most taxes are calculated. This process lowers an employee’s taxable income and increases their take-home pay.

The Tax-Saving Mechanism of a Cafeteria Plan

Employee contributions to a Section 125 plan are not subject to Federal Insurance Contributions Act (FICA) taxes, which are composed of Social Security and Medicare taxes. This saves the employee 7.65% on every dollar they contribute. This tax-saving benefit extends to the employer as well, who must match the employee’s FICA contributions and realizes the same 7.65% savings.

Employers realize an additional tax benefit related to federal unemployment taxes. The Federal Unemployment Tax Act (FUTA) imposes a payroll tax on employers, which is calculated based on employee wages. Because pre-tax contributions to a cafeteria plan reduce an employee’s official wages, the employer’s FUTA tax liability is also lowered.

To illustrate the savings, consider an employee who pays a $300 monthly premium for health insurance. If the employee is in a 22% federal tax bracket, they must earn approximately $385 before taxes to have $300 left to pay the premium. With a cafeteria plan, the $300 is taken directly from their gross pay, reducing their taxable income by the full amount.

Qualified Pre-Tax Benefits

A Section 125 plan can only be used to pay for specific, IRS-approved benefits. The most common qualified benefit is the employee’s share of premiums for employer-sponsored health insurance. This includes medical, dental, and vision insurance plans.

Another feature of many cafeteria plans is the option to contribute to a Health Savings Account (HSA). An HSA is a tax-advantaged savings account for qualified medical expenses available to individuals in a high-deductible health plan (HDHP). Contributions made to an HSA through a Section 125 plan are not subject to federal income or FICA taxes, and the funds can be withdrawn tax-free for medical costs.

Flexible Spending Accounts (FSAs) are also frequently offered. A Health FSA allows employees to set aside pre-tax funds to pay for out-of-pocket medical, dental, and vision expenses not covered by insurance. A Dependent Care FSA allows employees to use pre-tax dollars for work-related dependent care services for children under 13 or a qualifying relative.

While health-related benefits are common, other benefits can qualify, including adoption assistance and coverage for up to $50,000 of group-term life insurance. Non-qualified benefits like educational assistance, transportation benefits, and long-term care insurance cannot be paid for with pre-tax dollars through a Section 125 plan.

Employee Election and Contribution Rules

Participation in a Section 125 plan is governed by the rule of irrevocable election. This IRS regulation means that the benefit choices an employee makes during open enrollment are binding for the entire plan year. An employee cannot increase, decrease, or stop their contributions mid-year simply because they have changed their mind.

The primary exception is a qualifying life event (QLE). The IRS defines specific events that allow an employee to make mid-year changes to their benefit elections, provided the change is consistent with the event. Common QLEs include a change in marital status, a change in the number of dependents, or a change in employment status for the employee or their family that affects benefit eligibility.

A rule impacting Flexible Spending Accounts is the “use-it-or-lose-it” provision. This rule mandates that any money left in an employee’s Health FSA or Dependent Care FSA at the end of the plan year is forfeited to the employer.

To soften the use-it-or-lose-it rule, the IRS permits employers to offer one of two options. The employer can provide a grace period of up to two and a half months after the plan year ends, during which employees can use their remaining funds. Alternatively, an employer can allow employees to carry over up to $660 of unused Health FSA funds to the next plan year, but not both.

Employer Compliance Requirements

An employer must create a formal written plan document. This legal document is mandatory and must outline the specific rules of the plan, including eligibility, the benefits offered, contribution limits, and the plan year. Without a comprehensive written plan, the tax-favored status of the benefits can be disallowed by the IRS.

An administrative duty is to conduct annual nondiscrimination testing. These tests are designed to ensure the plan does not disproportionately benefit highly compensated employees (HCEs) or key employees. If a plan fails these tests, the tax advantages for the highly compensated group can be lost, making their contributions taxable.

A reporting requirement relates to the underlying welfare benefit plans offered through the cafeteria plan, such as a Health FSA. If a plan has 100 or more participants at the beginning of the plan year, the employer is required to file Form 5500 with the Department of Labor. Failure to file this form on time can result in significant financial penalties.