The Section 125 premium-only plan (POP), which is a very common type of cafeteria plan, allows employers to offer benefits in accordance with Section 125 of the Internal Revenue Code (hence the name).
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Specifically, a cafeteria plan allows employees to either:
- Get benefits like health insurance or life insurance on a pretax basis, or
- Receive a comparable—but taxable—benefit in cash.
Tell me more. What is a Section 125 POP?
A Section 125 POP lets your employees pay their insurance premiums with pretax dollars. However, the plan itself isn’t insurance. You still have to offer group health insurance separately.
A premium-only plan can include a “cash-in-lieu of benefits” provision for employees who don’t want coverage under the group plan. Employees who are enrolled in another group health plan (like a plan from a spouse or parent) can choose to receive a fixed amount of cash instead. Unlike premium payments, this dollar amount is taxed.
If an employee chooses cash, the benefit can’t discriminate based on “would be” premium costs. It must be a single, flat-dollar amount that you consistently offer to all eligible employees. And it shouldn’t be provided as a contribution toward individual health insurance.
Is health insurance pretax with a Sec 125 POP?
The short answer is “yes.” Employee contributions to group health insurance premiums are pretax as long as a Section 125 POP is in place. (Otherwise, their contributions are taxed.)
Employer contributions are always pretax.
What are the benefits of a POP?
Being able to pay for premiums using pretax dollars is the primary benefit for employees, but it’s also a win for you. The amount your employees contribute is subtracted from their total wages, which also reduces the amount of employee payroll taxes you need to pay.
A Section 125 POP doesn’t just apply to health insurance, either. These cafeteria plan benefits can be applied to premiums for other group insurance products such as:
- Term life (up to $50,000 in coverage)
- Other supplemental coverage
What’s the difference between a POP and a full Section 125 plan?
With a POP, only eligible benefit premiums and health savings account (HSA) contributions can be made on a pretax basis.
A full Section 125 plan also allows you to deduct eligible contributions to flexible savings accounts (FSAs) and dependent child care on a pretax basis.
How do I set up a POP at my business?
To set up a Section 125 POP, you need to put the details of the plan in writing. Everything in the plan must apply to all participants.
You can technically write your own plan document, but it’s safer to consult a health insurance broker who’s well-versed in all the compliance requirements.
Your document must include:
- A description of the benefits offered by the plan
- Eligibility and participation rules
- Steps for enrolling in benefits under the plan
- A note that elections can only be made during open enrollment (unless the plan allows for benefits election changes due to a change in status)
- The pretax contributions limit
- Details on how employer contributions can be made
- The plan year
The plan document must also state that only employees are eligible to participate—not employers, spouses, and dependents. But a participating employee’s spouse and dependents can receive benefits through the plan.
You’ll also need to write a summary plan description and give it to your employees. This summarizes all the details in your plan document in simpler terms.
What are nondiscrimination testing requirements?
POPs are subject to nondiscrimination testing requirements by the IRS. These tests ensure the plan doesn’t favor highly compensated employees. (A safe harbor applies to POPs that lets them automatically satisfy several requirements.)
To determine if you meet the requirements, your third-party administrator will conduct three tests:
- An eligibility test
- Contributions and benefits test
- Key employee concentration test
To complete these tests, they’ll look at company data like:
- Payroll information
- Benefit eligibility
- Benefit elections
If your Section 125 plan fails nondiscrimination testing, it must include gross income for highly compensated participants, detailing the contributions that would have been nontaxable. The tax-free benefits of the plan will be lost, and highly compensated participants will have their income estimated to include the salary reductions. These salary reductions must be reported as taxable income for W-2 reporting and income tax, and FICA and FUTA withholding.
Are POPs subject to ERISA requirements?
The Employee Retirement Income Security Act of 1974 (ERISA) is a federal law that sets minimum standards for most voluntary retirement and health plans. Although a POP is not an ERISA plan, the benefits paid through it are.
Reporting and disclosure requirements apply to any ERISA-covered benefits such as group health insurance, dental, and disability.
ERISA requirements include:
- Summary plan descriptions
- Written plan documentation
- Form 5500 filings for certain plans
How is Section 125 reported on a W-2 form?
When employees are enrolled in a Section 125 plan, you deduct their contributions before withholding certain taxes. While the payments aren’t included in taxable wages on W-2s, you may want to report the deductions in Box 14 on the W-2 form. It’s the “Other” box.
Keep in mind, not all benefits are excluded from the same taxes. For example, no federal income, Social Security, or Medicare taxes are taken from employees’ premiums. But premiums for employer-sponsored life insurance with coverage over $50,000 are subject to Social Security and Medicare taxes.
What other types of Section 125 plans exist?
In addition to Section 125 POPs, there are three other types of cafeteria plans. These include:
- Full flex plans: You make contributions for all plan-eligible employees. Employees then use those contributions to pay for various benefits. They can also make pretax contributions toward any benefit that your contributions don’t fully cover.
- Simple cafeteria plans: If you have 100 or fewer employees, these plans generally provide a safe harbor from certain nondiscrimination requirements, as long as you contribute to each eligible employee’s benefits.
- Flexible spending arrangements (FSAs): Employees can make contributions toward health care and dependent care on a pretax basis.
Are there any drawbacks to a Section 125 plan?
There are a few minor disadvantages for both employees and employers.
- Employees can’t change elections throughout the year without a qualifying life event (QLE), like a marriage or the birth of a child.
- Employees lose any unused funds in an FSA at the end of the plan year as well as any applicable grace period.
- Because a Section 125 plan reduces taxable income, it may also reduce benefits that are calculated by using an employee’s income, like Social Security.
- Employers are responsible for the cost, setup, and maintenance of the cafeteria plan.
- Employers who offer an FSA bear some risk of loss. The uniform coverage rule requires you to make the full amount elected by an employee (minus any reimbursement you’ve paid out) available any time during the plan year.
As you can see, the benefits of offering a Section 125 plan will typically outweigh the drawbacks. If you’re looking for an affordable way to round out your benefits package, a cafeteria plan could be a good thing to investigate.