A Section 125 Plan, sometimes known as a cafeteria plan or as a “premium only plan” (depending on the purpose of the document), allows employers to offer benefits per Section 125 of the Internal Revenue Code. A Section 125 plan enables employers to reduce employees’ gross income by allowing contributions to certain benefits to be pre-tax. These payroll deductions reduce the amount the company pays in payroll taxes.
What are the common types of Section 125 Plans?
Common examples of Section 125 plans include:
Premium Only Plan (POP)
A Section 125 Plan lets employees pay certain insurance premiums with pre-tax dollars. However, the plan itself is not insurance and employers still have to offer group health insurance and other benefits separately.
POPs are the most common component of all Section 125 plans because it is a requirement in order to allow employees to contribute to their healthcare benefits pre-tax. It is most often used in conjunction with Flexible Spending Accounts (FSAs) and Dependent Care Assistance Plans.
These Section 125 plan benefits can be applied to premiums for group insurance products such as:
- Disability (as long as benefits are taxed upon receiving)
- Term life (up to $50,000 in coverage, as long as benefits are taxed upon receiving)
A premium-only plan can include a “cash-in-lieu of benefits” provision for employees who don’t want coverage under the group plan (see more below). 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.
Flexible Spending Account
An FSA is a special account that you can place pre-tax money into in order to pay for IRS-eligible, out-of-pocket medical expenses and dependent care expenses.
Simple cafeteria plans
Simple cafeteria plans provide employers with 100 or fewer employees a safe harbor from certain nondiscrimination requirements in exchange for employer contributions to each eligible employee’s benefits.
With a full-flex plan, employers make contributions for all plan-eligible employees. Employees then use those contributions to pay for various benefits—this is also more generally known as a “cafeteria plan.” They can usually also make pretax contributions toward any benefit that your contributions don’t fully cover.
What if an employer wants to provide a cash-in-lieu option?
A cash-in-lieu benefit option is when an employer wants to make additional compensation available to employees as an alternative to the employer’s share of the health insurance premium. In general, that means the Section 125 plan can give employees a choice between receiving their compensation in cash or as part of an employee benefit. There are two tax advantages if the employee elects to receive their compensation as a benefit:
- Employee contributions toward cafeteria-plan benefits are made pre-tax.
- Employer contributions toward an employee’s cafeteria plan benefits are not taxed.
It’s important to note: not all Section 125 plans allow for this “cash-in-lieu” option. Employers are not obligated to offer cash-in-lieu. Review your documentation and talk with your broker before proceeding.
There are many instances where an employee may prefer to take cash instead of the insurance coverage offered by the employer’s Section 125 plan (e.g., their partner has better coverage). Under the IRS rules, this can only be done through an employer’s Section 125 plan. Employers must follow the rules outlined by the Section 125 plan cash-in-lieu option.
There are three main requirements that employers must follow in offering a cash-in-lieu option.
- Cash payments are taxable, so employees must be allowed to choose between taxable and non-taxable benefits. This means that the cash-in-lieu option must not be the only option offered under the cafeteria plan.
- The payments must be included in the recipient’s W-2 taxable wages.
- The amount should be set to a number that is consistently offered to all eligible employees to comply with non-discrimination requirements.
How can employers set up a Section 125 plan?
For a Section 125 plan to be compliant with regulations, certain documents are required. These detail the legal and employer-specific aspects of the employer’s benefit plan, which are required under both the Internal Revenue Code and, oftentimes, the Employee Retirement Income Security Act (ERISA). A broker, a benefits attorney, or even a third-party administrator should be able to assist with providing these documents.
Because many employee benefits are covered by ERISA, they require a summary plan description (SPD). The purpose of this is to inform employees about the various aspects of the benefits plan being offered. The law requires that the SPD be provided to all eligible employees. Employers can technically write their own plan document, but it’s easier to consult a health insurance broker or an attorney who knows the compliance requirements.
The employer’s plan document must include:
- A description of the benefits offered by the plan
- Eligibility and participation rules
- A provision that elections can only be made during open enrollment (unless the plan allows for benefits election changes due to a change in status)
- The pre-tax contributions limit
- Details on how or if employer contributions are made
- The plan year
Depending on the benefits offered, there may be additional information that is required.
The plan document must also state that only employees are eligible to participate in the plan. Employers, spouses, and dependents cannot contribute to the plan. However, a participating employee’s spouse and dependents can receive benefits through the plan as long as the employee is enrolled (note: there may be certain exceptions under retirement benefits plans).
What are non-discrimination testing requirements?
Many Section 125 plans, such as POPs, are subject to nondiscrimination testing requirements by the IRS. For Health FSAs and Dependent Care FSAs, there are additional tests in addition to POP nondiscrimination testing. There are three tests for Section 125 plans, all of which are listed below. These tests ensure the plan doesn’t favor highly compensated employees, and third-party administrators ensure employer compliance.
- Cafeteria Plan Eligibility Test: For the employer to pass this test, the plan must be offered to all eligible employees. Certain employees may be excluded such as union employees and non-resident aliens. In addition, employers cannot have different requirements for different employees in order to join the plan. The same goes for the premium paid through the plan which must be the same for all employees. Lastly, the waiting period must be less than 3 years.
- Cafeteria Contributions & Benefits Test: This test states that a plan cannot discriminate in favor of highly compensated participants as to contributions and benefits. A highly paid employee includes:
- An officer of the company.
- A shareholder who owns more than 5 percent of the voting power or value of all classes of the employer’s stock.
- Highly compensated—for 2023 testing, more than $135,000 in compensation the prior year (for 2024 testing, more than $150,000 the prior year), and if elected by the employer, in the top-paid 20 percent of employees.
- A spouse or dependent of an individual described in the three bullet points above.
Examples of plans that likely are not discriminatory include plans that consist solely of health insurance benefits and the employer pays for 100% of the cost or pays 75% of the cost of the most expensive plan offered.
If additional benefits, such as an FSA or Health Savings Account (HSA), are offered, then in order to pass the Cafeteria Contributions & Benefits Test, the percentage of benefit dollars compared to compensation for the Highly Compensated Employee group should be equal to, or less than, the same percentage for non-Highly Compensated Employees.
- Cafeteria Plan Key Employee Concentration Test: This test measures the amount of pre-tax benefits provided to key employees versus all other employees. A key employee for 2023 testing is:
- An officer who earned an annual pay of more than $200,000 in 2022 (for 2024 testing, an officer who earns $215,000 in 2023); or
- An employee who is either a 5% owner or a 1% owner who earns more than $150,000.
To pass the Key Employee Concentration Test, key employees cannot receive more than 25% of the pre-tax benefits from the plan.
To complete these tests, the employer (or designated professional) will need to take a look at company data like:
- Payroll information
- Benefit eligibility
- Benefit elections
- Employee contributions
If an employer’s Section 125 plan fails nondiscrimination testing, it must include gross income for highly compensated participants, detailing the contributions that would have been nontaxable. It may also mean that the plan will lose its tax-free benefits. In that case, highly compensated participants will have their income estimated to include the salary reductions. In some cases, it may cause the employer to lose pre-tax contribution privileges if corrections are not made. These salary reductions must be reported as taxable income for W-2 reporting and income tax, and FICA and FUTA withholding.
How is Section 125 reported on a W-2 form?
When employees are enrolled in a Section 125 plan, employers deduct their contributions before withholding certain taxes. While the payments aren’t included in taxable wages on W-2s, employers may want to report the deductions in Box 14 (and dependent care benefits also in Box 10) on the W-2 form.
It’s important to note that 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.
When must employees make elections under a Section 125 Plan?
An employee must make elections under a Section 125 plan before the first day of the plan year, or the date taxable benefits would currently be available (e.g., within their election period if hired during the year). This means that most employees will make their elections during an annual open enrollment period, with the elections taking effect on the first day of the plan year. Employees who become eligible for benefits during a plan year, such as new hires, usually make their choices during an initial enrollment period.
What are the Pros and Cons of Section 125 Plans?
As explained above, there are many benefits to Section 125 plans, including employee tax savings. Through these plans, employees can save on federal, state, and local withholding taxes while helping to pay for eligible out-of-pocket expenses. Next, given that these funds are placed into this account on a pre-tax basis, it reduces the taxable income present on Form W-2. Lastly, a Section 125 plan helps employers reduce payroll and tax liabilities, including FICA and FUTA.
These benefits explained above can help offset the initial plan setup fee and even help the employer save substantially in the long term. However, before setting up a plan, employers need to look at the potential drawbacks of a Section 125 plan. There are a few disadvantages for both employees and employers.
- Employees have a limited time frame to use their funds. Section 125 plan participants must use the funds during the plan year, or those funds will be lost. Thus, employees need to plan how they will utilize their funding.
- Employees can’t change elections throughout the year without certain qualifying life events (QLEs), like significant cost change under the group health plan or an employee’s spouse dropping coverage during their own open enrollment period.
- Section 125 plans require employees to fund expenses upfront. For certain benefits, expenses must be paid out-of-pocket first and then are reimbursed after a claim is made.
- Because a Section 125 plan reduces taxable income, it may also reduce benefits calculated by using an employee’s income, like Social Security.
- Employers may have to pay a fee in order to set up the Section 125 plan, depending on their broker or third-party administrator. This fee is minimized as a result of the significant savings present over the long term.
- There are also maintenance costs for the Section 125 plan. Usually, Section 125 plan administration can be taken care of by an employee benefits specialist who assists the employer with the health insurance policy or other benefits program.
- Employers who offer an FSA bear some risk of loss. The uniform coverage rule requires employers to make the full amount elected by an employee (less any reimbursement) available any time during the plan year.
As seen above, the benefits of offering a Section 125 plan will typically outweigh the drawbacks. For employers looking for an affordable way to round out their benefits package, a Section 125 plan could be a good option.