Section 125 Premium Only Plan rules & regulations

IRS code Section 125 allows an employer to set up a Premium Only Plan (POP), where an employee's insurance premium contributions can be deducted from his or her payroll on a pre-tax basis. This can save employees up to 40% on income taxes and payroll taxes. The employer also saves on these taxes.

Overview of POP rules & regulations

1. Eligibility. The following organizations can set up a POP for W-2 employees:
2. Legal documents. The employer must set up a Plan Document and Summary Plan Description (SPD) before the effective date of the Section 125 POP plan. These documents explain the rules of the plan and are distributed to all employees. The employer should sign the plan document and keep it on file.
3. Salary Reduction Agreement. With a Section 125 POP plan, each eligible employee is given the option to opt in to a Salary Reduction Agreement with the employer, in which he or she agrees to the amount of pre-tax salary to be withheld from wages for health care coverage.
4. Nondiscrimination testing. Employers cannot discriminate in favor of highly compensated individuals. If you have any question about discrimination, we recommend performing nondiscrimination testing and keeping these tests on file in the event of an audit.
5. Employee enrollment. Employees can only enroll:
   • During an annual open enrollment period specified in the plan document
   • Within a specified period following date of hire
   • The date an employee first becomes eligible under the plan document
   • Under other special circumstances outlined in the plan document.
6. Changes to salary reduction. Once in place, changes to the Salary Reduction Agreement can only be made at the beginning of the plan year. Generally, the only exceptions are qualifying life events, which cannot be made retroactively, and include changes in:
   • C Corp
   • S Corp
   • Partners
   • LLCs
   • Sole Proprietorships
   • Non-Profits
   • marital status
   • number of dependents
   • employment status
   • eligibility requirements
   • residence
   • adoption proceedings
   • cost or coverage
   • other laws or court orders

Conclusion

POPs are a common way employers help employees pay for health insurance premiums tax-free. However, it’s important to note that they are typically used in combination with group health insurance plans, which are out of reach for many small organizations.

For these employers, health reimbursement arrangements (HRAs) are an ideal alternative, as they allow employers to offer employees the same tax savings for individual health insurance premiums—with the primary difference being that employees are reimbursed for purchases versus seeing a deduction on their paystub.

This post was originally published September 15, 2012. It was last updated October 14, 2020.