How Do Section 125 Plans Work?

Section 125 Cafeteria Plans, which are created by employers, allow employees to set aside pretax dollars for insurance premiums, qualified medical expenses and qualified child care expenses. Named after the IRS code that allows these benefits, Section 125 Cafeteria Plans offer tax benefits to both employers and employees.

What You Need to Know

Cafeteria plans allow employees to pay for many benefits plans with pretax dollars, helping them to better afford healthcare expenses and save on taxes.

With these plans, employers can offer a variety of benefits and also save on taxes.

Employers must understand the rules involved in setting up and managing a compliant Section 125 Cafeteria Plan.

How Do Cafeteria Plans Work?

Cafeteria plans, also called Section 125 plans, don’t actually provide health insurance or other coverage. They merely allow employees to pay their share of premiums for qualified coverage for themselves, their spouses and dependents on a pretax basis. Qualified coverage includes medical, dental, vision, life and disability income insurance, as well as qualified unreimbursed healthcare and dependent care costs. Employers provide coverage choices and employees elect the benefits they want to pay for with pretax dollars. An employer then deducts the appropriate amount from each employee’s paycheck before taxes are taken out.¹

What Are the Types of Cafeteria Plans?

Employers can choose among several types of benefit plans under Section125, including:²  

• Premium only plan (POP)—Also called a premium payment plan or premium conversion plan, this is the most basic and popular Section 125 plan. It lets employees pay their portion of premiums for qualified benefits with pretax dollars. If an employee under a POP declines insurance coverage, an employer may offer instead a cash payment in the form of additional taxable wages.
• Flexible spending arrangement/Dependent care assistance program (FSA/DCAP)—Employees contribute pretax dollars to one of these accounts to pay for qualified healthcare expenses (healthcare FSA) or qualified dependent care expenses (DCAP). Plan requirements include caps on contributions and the “use it or lose it” rule, which requires that any employee contributions not spent on qualified expenses during a predesignated period, such as a calendar year, revert back to the employer. FSAs may be the only element of a section 125 plan an employer offers or it may be offered in conjunction with a premium payment option. (Health insurance premiums are not a qualified expense for healthcare FSAs.)
• Health savings account (HSA)—Used in conjunction with a high-deductible health insurance plan (HDHP), this type of account allows employees to save pretax dollars for healthcare expenses. Earnings on saved money accumulate tax free, and withdrawals for qualified expenses are not taxed. Employers can contribute to employee HSA accounts and, unlike FSAs, leftover balances roll over from year to year.
• Full cafeteria or full-flex plan—Employers make contributions to employees’ accounts to be used for any benefits offered. Employees may also make pretax contributions toward any benefit that the employer contributions do not fully cover. In some plans employees who elect not to purchase any benefits may take the amount of their employer contribution as taxable wages.
• Simple cafeteria plan—This plan, designed for companies with 100 or fewer employees, allows small employers to offer Section 125 benefits without having to comply with some of the rules larger employers must follow. (See next section for more.)

What Are Cafeteria Plan Requirements?

Any employer with employees who pay U.S. income taxes may sponsor a cafeteria plan. That includes C corporations, S corporations, LLCs, partnerships and sole proprietorships. Participants in a cafeteria plan must be able to choose at least one taxable benefit (such as cash) and one qualified benefit.³

Employers must have a master plan document that details all legal aspects of the plan. In addition, they must give employees what’s known as a summary plan description (SPD), which explains in plain English all aspects of the flexible benefits plan. The SPD  must be updated and distributed at least every five years if there have been changes to the plan; every 10 years if there have been no changes.⁴

Employee tax advantages are only valid under section 125 if their elections remain in effect for the entire plan year. Elections must be made anew every year. Changes can only be made during the open enrollment period or when an employee experiences a qualifying event. (See more on qualifying events below.)⁵

Firms with more than 100 employees must adhere to IRS nondiscrimination rules, which prohibit  a plan from favoring highly compensated employees. Nontaxable benefits for key employees cannot add up to more than 25% of the total benefits provided to all company employees.⁶

Employers with 100 or fewer employees may establish simple cafeteria plans to avoid some of the nondiscrimination rules.

What Are the Benefits to Employers?

Employers who offer a wide range of benefits and the opportunity to pay for some of those benefits with pretax dollars have an advantage in attracting and keeping the best talent. In addition, cafeteria plans let employers save on benefits since they only pay for coverage that employees elect.

There are also tax savings. Contributions made to employees’ cafeteria plan benefits are not taxed, nor does an employer have to pay the 7.65% FICA tax (for Social Security and Medicare) on employee wages that are set aside for benefits. The savings work out to about $15 for every $200 a month an employee contributes pretax.⁷

What Are the Benefits to Employees?

Because contributions to a cafeteria plan reduce an employee’s overall taxable income, employees can save at tax time. Pretax dollars also help an employee better afford healthcare expenses. Say, for example, an employee in the 30% tax bracket puts away $200 a month pretax for qualified health expenses. If that employee had to use taxable earnings for the same $200 in expenses, they would have only an estimated $140 a month after taxes are deducted.⁸

FSAs can also help employees budget and save for healthcare and/or dependent care expenses.

When Can You Sign Up for Cafeteria Plans?

Most employees sign up for cafeteria plans during the annual enrollment period for employer-sponsored benefits. In general, an employee’s elections stay in place for the entire plan year.

Under certain circumstances, employees may revoke an election and/or make a new one outside of open enrollment if they experience a qualifying life event,⁹ such as:

• Change in marital status
• Change in the number of dependents
• Change in residency
• Change in employment status
• Change in the cost or type of coverage
• Loss of coverage
• Eligibility for Medicare
• Government exception (such as the changes made to accommodate COVID-19 in 2020).¹⁰

It’s important to remember that employees can only make changes that are consistent with the life event. For example, an employee who gets married can add their spouse to coverage, or drop coverage entirely if they are gaining coverage under the spouse’s plan, but they wouldn’t be allowed to change the plan option (e.g., from an HMO to a PPO).

Next Steps

Employers interested in offering Section 125 Cafeteria Plans may need to find a qualified, third-party plan administrator who can help them set up and document a qualified section 125 plan. Administrators can also provide up-to-date information on plan requirements and changes, such as the recent COVID-19–related rule changes.