The Section 125 Plan is a benefit program sponsored by the employer that gives employees the freedom to choose from an array of qualified benefits to be paid for on a pre-tax basis. It is termed as such because Section 125 is where the provision for the administration of these types of plans is found in the IRS or US Tax Code. They are also called “cafeteria” plans because, like a cafeteria, the employee has his choice from a full menu of different options.

Section 125 Plan

With a Section 125 Plan, employees can avail of various benefits. Health, life, and dental plan are the usual suspects, but employers can also run through products such as disability insurance, and funding for Health Savings Accounts (HSAs), cancer insurance, and eye care, among others.

The IRS Code also specifies which employees can or cannot participate in a Section 125 Cafeteria Plan. Sole proprietors and 2% shareholders of S Corporations can’t for example. Another key provision in the tax code the Section 125 Plan should in no way discriminate in favor of what are called “highly compensated employees” or HCEs and “key employees”. The IRS code has the specific definition for who are considered as HCEs and key employees, but essentially it means that a Section 125 Plan cannot give any favors to its officers and employees who happen to be co-owners when it comes to benefits and eligibility.

Section 125 Plan: 125 Cafeteria Plan Advantages

Why bother having a 125 Cafeteria plan? The resulting tax savings is one of the biggest advantages. Cafeteria plans allow employees to pay for benefits on a pre-tax basis. That is, the premium is deducted from the employee’s taxable income, thereby reducing his Federal withholding, FICA tax, and Medicare tax. The employee basically takes home a bigger paycheck without the employer increasing payroll costs.

The sponsoring employers also get to benefit from reduced taxes because the decrease in an employee’s taxable income would also mean a reduction in the matching employer share of FICA and Medicare taxes as well as FUTA taxes. There’s also a morale boost that comes when the employee realizes that a smorgasbord of benefits are available to him. Cafeteria plans allow employers to offer benefits that they could not otherwise afford. And because the benefit payments are pre-taxed, it costs the employee less to “buy” the benefits than it would if s/he did it on his or her own.

The biggest downside of Section 125 Cafeteria plans are the administrative requirements. You’ll need to prepare a plan document and keep it up to date to avoid running afoul of the IRS. You will probably want to get some legal and administrative help to keep the plan running smoothly. There is also a cost involved; the National Conference of State Legislatures estimates that an employer will pay up to $100 per employee to set up and administer a Section 125 Cafeteria Plan; the tax savings, however, can easily cover this cost.

Section 125 Plan Closing Comments

A Section 125 Plan can be a great tool to expand your employees’ benefit options while also benefiting your company.

Check out our site to know more about a Section 125 Plan, specifically the Premium Only Plan (POP). If you already have an existing plan, then you can learn more about our automatic document solution that can provide prompt and cost-effective updates to your Section 125 Plan Document.

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