As employers prepare for open enrollment and the upcoming benefits season, now is a good time to revisit the basics of Section 125 plans. Section 125 plans are named for the IRS code that authorizes them. Section 125 authorizes employers to offer certain benefits on a tax-favored basis through a written benefit plan. Most commonly known as Cafeteria Plans, they are also known as Premium Only Plan, Premium Conversion Plan, or Flexible Benefits Plan.
Under a cafeteria plan, employers can have co-share of costs but employees will pay with pre-tax dollars, which provides a tax benefit to employees by reducing their taxable income base. The plan document establishes the terms under which employees may elect pre-tax benefits and serves as the legal basis for the tax treatment of those elections. Among other things, it identifies the benefits offered, defines employee eligibility, sets election procedures, specifies when mid-year election changes are permitted, and outlines the rules governing plan administration.
Programs that can fall under 125 Plans include:
- Health insurance premiums
- Flexible Spending Accounts (FSAs)
- Dependent Care Assistance Plans (DCAP)
- Commuter and parking benefits
- Health Savings Accounts (HSAs)
- Premium Only Plans (POP)
The plan may make benefits available to employees, their spouses, and dependents. As for domestic partners, they may not be given the opportunity to select or purchase benefits offered by the plan, but the domestic partner may benefit from the employee’s selection of family medical insurance coverage or of coverage under a dependent care assistance program. It may also include coverage of former employees but cannot exist primarily for them.
From a tax perspective, since deductions are pre-tax, employees lower their taxable income, which increases their take-home pay. At the same time, employers save 7.65% per dollar deducted on payroll taxes. Having a 125 Plan does not generally require a Form 5500 filing.
Who should have a Section 125 plan? Any employer that has employees pay for qualified benefits through pre-tax salary reductions. Before they do that, the employer should have a compliant Section 125 plan in place prior to engaging in the pretax deductions. Again, common pre-tax deductions are found for medical, dental, or vision insurance; health flexible spending arrangements (FSAs); or dependent care assistance programs. However, a cafeteria plan cannot make advance reimbursements for medical expenses.
Interestingly enough, employers cannot assume that simply taking out the employee’s share through payroll is pre-tax. Everything depends on the plan document. If the plan is not written correctly, employees do not gain the tax advantages of the Section 125 plans. Even when an employer participates in a Professional Employer Organization (PEO), it remains responsible for conducting due diligence to ensure its benefit plans comply with applicable requirements. Employers should not assume that a plan is compliant without verification. If a compliance issue is later discovered, there may be no opportunity to correct the error retroactively. To help mitigate this risk, employers should review the following items with their benefits counsel:
- Do we have a written Section 125 plan?
- Does the plan accurately reflect the benefits we currently offer?
- Are employee elections and mid-year election changes administered in accordance with the plan's terms?
If the answer to any of these questions is uncertain, a more thorough review of the plan documents should be conducted to ensure compliance. Taking out pre-tax deductions on a plan that is not compliant could lead to tax surprises for the employee and penalties and fines for the employer for underreporting payroll taxes.
Source: Metz Lewis Brodman Must O'Keefe 7/13/26, 125 Plans