Section 125 Cafeteria Plans: Benefits, Pros, and Cons Explained

Cafeteria plans are referred to as Section 125 because of the tax code where the law is spelled out and are a way for employers to use pretax earnings to cover qualified medical expenses. These types of programs are appealing to employees because it offers them a greater level of choice in determining their own healthcare benefits (think choosing from food selections at a cafeteria). For business owners, a cafeteria plan can be a good way to reduce state taxes and payroll expenses.

What is Section 125 Cafeteria Plan?

A Section 125 Cafeteria Plan is a type of employee benefits plan that allows employees to choose from a variety of pre-tax benefits, helping them save on taxes while gaining access to essential healthcare and other benefits. Named after Section 125 of the Internal Revenue Code, these plans provide a tax-advantaged way for employees to pay for qualified benefits using pre-tax dollars, which reduces their taxable income.

Employers also benefit from Section 125 Plans by reducing their payroll tax liability since employee contributions are deducted before taxes.

Several working Americans have Section 125 Cafeteria Plan during their professional life. However, many people fail to take advantage of the benefit options of cafeteria plans. If it is used the right way, a cafeteria plan can enhance your take-home amount without any kind of expenditure.

The same account can be used for reimbursing the staff member for some kinds of insurance premiums, dependent care, and vision expenses, dental insurance, and medical expenses throughout the claim period or the plan year.

With this plan, an employee can easily reduce the gross income amount from worker’s paycheck used for calculating Social Security, Federal, and some State tax amount. All of these can amount to a saving of 25%-40% for each tax-free dollars you are contributing to the program.

How Do Section 125 Cafeteria Plans Work?

A qualified section 125 cafeteria plan operates by allowing employees to allocate a portion of their salary toward benefits before taxes are applied. Employees can choose from different benefit options that best suit their needs, similar to selecting items from a cafeteria menu—hence the name. Businesses that offer a cafeteria plan to their participating staff members allow them to make their own choices about group health programs, health savings accounts, life insurance, dental and vision expenses, and long-term care.

Under a Section 125 Plan, employees can contribute pre-tax dollars to cover expenses such as:

• Health Insurance Premiums
• Flexible Spending Accounts (FSAs)
• Health Savings Accounts (HSAs) (if paired with a high-deductible health plan)
• Dependent Care Assistance Programs (DCAPs)
• Commuter Benefits (in some cases)

For employers, a section 125 plan allows them to save money on both payroll and taxes through the tax-sheltered status of the taxable benefit.

Types of Section 125 Cafeteria Plans

There are several variations of a Section 125 Cafeteria Plan, each offering different benefits and structures. Below are the most common types:

1. Premium Only Plan (POP)

A Premium Only Plan (POP) allows employees to pay for their health insurance premiums on a pre-tax basis. This type of plan is the simplest form of a Section 125 Plan and is widely used by employers to help employees save money on their healthcare expenses.

2. Flexible Spending Accounts (FSAs)

FSAs allow employees to contribute pre-tax funds to cover eligible medical and dependent care expenses. There are two primary types of FSAs:

• Health FSA: Covers medical, dental, and vision expenses not covered by insurance.
• Dependent Care FSA: Covers childcare or elder care expenses for dependents.

FSAs come with an annual contribution limit and a use-it-or-lose-it rule, meaning unused funds may be forfeited at the end of the plan year unless the employer offers a grace period or carryover option.

3. Full Cafeteria Plan

A Full Cafeteria Plan offers employees a broader selection of benefits, including health insurance, FSAs, dependent care, and even life insurance. Employees can customize their benefits package based on their needs.

4. Health Savings Accounts (HSAs)

While HSAs are not technically a cafeteria plan benefit, they can be included within a Section 125 Plan if the employer offers a high-deductible health plan (HDHP). HSAs allow employees to save pre-tax dollars for future medical expenses, and the funds roll over year to year.

What are the Benefits of Cafeteria Plans?

Section 124 Employee Benefits Flex Plans are one of the most underused and underrated programs that are available for small businesses out there. It allows crews to set aside a portion of their pre-tax basis salary for covering child-care or qualified medical expenses.

Here are some of the flexible benefits of the package.

Pre-Tax Medical Insurance Premiums Deduction

It is a premium-only plan. So, it enables employees to choose to withhold some amount of their pre-tax salary for paying their insurance premiums contribution for a majority of the employer-sponsored welfare and health benefit insurance packages.

With this health savings account, you can take advantage of favorable tax treatments for the advantages offered. Many companies have this set through the payroll provider. The Premium Only Plan (POP) is a simple kind of Section 125 insurance. It doesn’t need much maintenance once you set it up through the payroll.

Unreimbursed Medical Expenses Out of Pocket

A Flexible Spending Account (FSA) will let an employee fund some of their medical expense on a pre-tax mode through salary reduction for paying out the expenses incurred that aren’t covered by the insurance.

An average working team member in the USA spends over $100 every year on these kinds of benefits. If you avail FSA, your taxable income gets reduced and increases the percentage of the money you take home.

Flexible Account Spending for Dependent Care

Dependent care is an incredible qualified benefit for the workers who are paying for parent care or childcare. Some staff member fails to take advantage of this or might even be unaware of the considerable tax savings.

Employees might hold back an amount of $5000 every year of their pre-tax salary for the qualified expenses of dependent care. This includes expenses that they pay while they work, attend school full-time, and pre-tax salary.

Qualified dependent care expenses are-

• Caring for a child under 13 years of age
• Dependent incompetent of caring for himself
• Summer day camps

Other than paying for dependent care using the pre-tax considered wages, you can save 20%-40% on child-care expenses.

Tax Advantages of Section 125 Cafeteria Plans

Both employees and employers benefit from the tax advantages provided by a Section 125 Plan:

For Employees:

• Contributions to eligible benefits are made pre-tax, reducing taxable income.
• Lower taxable income results in lower FICA (Social Security & Medicare) taxes.
• Employees gain access to affordable healthcare options and tax savings on dependent care expenses.

For Employers:

• Employers save on payroll taxes, including FICA and FUTA taxes, as employee contributions lower taxable payroll.
• Reducing taxable wages also lowers workers’ compensation premiums.
• Offering a Cafeteria Plan enhances employee retention and satisfaction by providing valuable benefits.

How to Set Up a Section 125 Plan?

It is important to be compliant with the rules of Section 125 regulations. For that, you need a few documents. These are the employer and legal-specific aspects of the benefits of the employer that is required under both the Employee Retirement Income Security and Internal Revenue Code. A benefits attorney, broker, and third-party administrator should be able to help with offering these documents for Section 125 Cafeteria plan.

As multiple employee health benefits are covered by ERIA, they ask for a summary plan description. The main aim of this is to let the workers learn about the different aspects of the benefits which are being offered.

As per the law, the SPD has to be provided to all crews that are eligible. So, employers can create their own plan document with at least one qualified benefit. However, it is always better to talk to a healthcare insurance attorney or broker who has a better idea about the compliance requirements.

The document of the employer should include-

• Participation and eligibility package participants
• A description of the benefits provided by the plan
• Details on how employer contributions are made
• A provision that elections can be made during the time of open enrollment
• The pre-tax contributions limit
• The plan year

Based on the health benefits offered by paying the medical insurance premiums, some added details might be required. The document of Section 125 Cafeteria created by the employer should state that just workers are eligible to be a part of the plan.

Spouses, employers, and dependents can’t contribute to this health package at additional cost. But a participating employee’s dependents and spouses might receive benefits through the plan until the time the participating worker is enrolled.

Compliance Requirements for Section 125 Plans

Employers offering Section 125 Cafeteria Plans must comply with IRS regulations and ensure their plans meet legal requirements:

• Written Plan Document: Employers must have a formal written plan outlining the benefits offered, eligibility rules, and contribution limits.
• Non-Discrimination Testing: To prevent tax-favored benefits from disproportionately favoring highly compensated employees, plans must pass non-discrimination testing annually.
• Employee Election Rules: Employees generally make benefit elections during open enrollment, and changes are only permitted for qualifying life events (e.g., marriage, birth of a child, loss of coverage).
• COBRA Compliance: If an employer is subject to COBRA regulations, they must provide continuation coverage options for health benefits.

Who is Eligible for Section 125 Packages for Federal Income Tax Purposes?

Any employer that has employees subjected to paying income taxes in the US can offer a Section 125 Cafeteria plan. It includes S-corporations, C-corporations, governmental entities, partnerships, LLCs, or sole proprietorships. But not all types of companies will be able to offer certain benefits provided as per the carrier requirements.

Common Mistakes Employers Make with Choice Benefits Plan

Section 125 Cafeteria plan was started in 1979 as this is when the health insurance plan of the Internal Revenue Code takes effect. Since the introduction, it has become so popular that it is surprising to find an employer that doesn’t offer one. Even the smallest employers offer medical insurance of Section 125 Cafeteria.

But like everything else, there are rules that should be followed for the health protection policy premiums. And, where there are rules, mistakes can be made. Take a look at the mistakes to make sure that you don’t make them.

No Plan Document

It is not possible to have a Section 125 Cafeteria Plan if you do not have a plan document. When you give employees the choice between receiving less than the whole amount or receiving the entire amount of the pay, on a pre-tax basis, the share premiums for benefits, like the coverage under the group health solutions, you should have a document.

In case you do not have on, it might imply that your business might be a problem. A plan document is very simple but is something that is essential for Section 125 Cafeteria Plans.

Plan Documents Not Being Prepared Carefully

One of the most common mistakes that employers tend to make is creating the plan document but not drafting it properly. Usually, these are canned documents, which a vendor has thrown in or an employer came across over the internet. The issue is if the document isn’t completed correctly, it fails to satisfy the document requirement of the health insurance, internal revenue service, and US Treasury regulations that accompany it.

Some of the examples of the documents not being drafted properly are given below-

• Wrong Plan Year: The plan year that has been mentioned in the document has to comply with what you are doing. For instance, documents specifying that the plan year is the fiscal year starting 1st May of every year. In case that is what you are doing, it’s okay. However, sometimes, your business is just holding the annual enrollment period in the month of November and the new employee elects are going to be effective, then there has to be a good reason as to why the documents don’t specify that the document plan year and the calendar year is the same.
• Wrong Kind of Entity: It is a problem when the plan document states that you are LLC when you are just a corporation that exist primarily in your state. That at least tells you that your document has not been prepared properly.
• Specimen or Sample Documents: Your plan shouldn’t have words, such as Specimen or Sample at the top of the first page, on the signature page, on the footer, or anywhere else.

Letting Wrong People Participate in It

For the eligibility requirements in the cafeteria plan, a person has to be current, and in certain cases, the former employees of the employer. If someone is not an employer, they can’t participate in a cafeteria plan.

A member of an LLC becomes a part of the partnership, and over 2% of shareholders in the S corporations can enroll in the benefits, which an employer is offering. However, they can’t pay for the benefits with the help of pre-tax dollars using a 125 cafeteria plan.

Benefits are Excluded

In case your business lets its employees pay their share of health insurance premiums of the 125 Benefits Choice Programs they have chosen using pre-tax dollars, ensure that those benefits have been identified in the 125 Cafeteria Plan. There are a lot of ways to do it.

However, often, documents are set up to that they simply refer to the spending accounts, such as DCAP and Health FSA. In case the document isn’t set up for referring to the group health plan, a group term life insurance, etc. the premium amount for the programs can’t be paid on the pre-tax basis from the cafeteria plan. It is an internal revenue service requirement and is quite basic. However, it can be overlooked.

Forgetting that the Health FSAs Comply with HIPAA Medical Privacy Rules

You can take Health FSA as a kind of designated account in a bank. People put money in it and then they have specific kinds of medical expenses, such as deductibles and unreimbursed copays, they can use the remaining funds in the health FSA to reimburse or to pay for the expenses.

This isn’t too far off the mark, but the HIPAA medical privacy regulation takes a health FSA to be a kind of self-insured group health package. It means that if your business is providing a Health FSA to the team members, it is subject to HIPAA.

For some team members, the health FSA might be the only benefit they offer subject to a full scale of the HIPAA medical privacy regulations. In case your business is not providing one, do not wait until you have a complaint or a problem to check the HIPAA compliance.

Who Can Offer a Section 125 Plan?

Section 125 Plans are typically offered by employers of all sizes, including:

• Small Businesses
• Mid-Sized Companies
• Large Corporations
• Nonprofits

However, certain entities, such as government employers, may have restrictions on implementing Cafeteria Plans due to tax regulations.

Get Started with Your Employee Benefits

A Section 125 Cafeteria Plan is a valuable tool that helps employees save money on healthcare and dependent care expenses while allowing employers to reduce payroll tax costs. These plans offer customizable pre-tax benefits, making them a great option for businesses looking to enhance their employee benefits package.

Employers should work with a knowledgeable group health insurance provider to ensure their Section 125 Plan is structured correctly and compliant with IRS regulations. By offering a Cafeteria Plan, businesses can improve employee satisfaction, retention, and overall financial well-being.

Call us today at 800-903-6066 if you’d like to learn more about the benefits of offering a section 125 cafeteria plan! We offer FREE cost estimates for business owners and employee groups, over the phone and through our online form. We’re happy to answer your questions! 

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Frequently Asked Questions

Can team members use HSA funds for non-medical expenses?

No, team members cannot use HSA funds for non-medical expenses without incurring penalties. HSA funds are intended for qualified medical expenses only and using them for non-medical expenses can result in taxes and penalties.

How can employers make sure that their Section 125 plan is compliant with changing IRS regulations?

Employers can ensure their Section 125 plan remains compliant with changing IRS regulations by regularly reviewing and updating their plan documents to reflect any new requirements. They should also stay informed about any updates or changes to IRS regulations related to Section 125 plans and work with legal or tax professionals to ensure their program remains in compliance. Additionally, employers should communicate any changes to workers and provide training on how to properly utilize the plan in accordance with IRS regulations. Regular audits of the plan can also help identify any potential compliance issues that need to be addressed.

Without a Section 125 plan in place, what would happen to an employee's payroll contribution to HSA?

Without a section 125 plan in place, an employee's payroll contribution to an HSA would be subject to federal income tax, Social Security tax, and Medicare tax. This means that the crew would effectively be paying more in taxes on their HSA contributions compared to if they were made through a section 125 plan, which allows for pre-tax contributions.