Many employers find it challenging to provide a budget-friendly and attractive benefits package. Although benefits costs are impacted by factors like healthcare costs, which are continually rising, a section 125 plan, or cafeteria plan, allows you to boost your employee benefits while staying in-budget with its significant tax savings.
Employers wanting to compete for top talent can offer section 125 plans as a fringe benefit to help attract and retain employees. When used correctly, a cafeteria plan can increase an employee’s take-home pay without any change in compensation.
Let’s take a comprehensive look at section 125 plans to help you better understand how they work for employers and employees.
What is a section 125 plan?
A Section 125 plan is part of the IRS code that enables and allows employees to take taxable benefits, such as a cash salary, and convert them into nontaxable benefits. A plan participant contributes a portion of their earnings on a pre-tax basis to cover the cost of the benefits.
The IRS considers the following types of benefits to be qualified under Section 1251:
- Health insurance premiums (medical, dental, and vision)
- Accident and disability insurance
- Retirement deposits
- Adoption assistance
- Dependent care assistance
- Group-term life insurance coverage
- Health savings accounts (HSAs)
Section 125 plans are tax-advantaged. Depending on their location, employees can save between 28% to 48% in total federal, state, and local taxes on a wide variety of out-of-pocket items.
Because cafeteria plan contributions are made with pre-tax deductions, an employee’s overall taxable income is reduced by the amount contributed toward the plan That means the employee will pay fewer federal income taxes and Medicare and Social Security taxes. Pre-tax deductions also reduce the employer’s FICA and FUCA tax liabilities, plus the employer can save an extra 7.65% on their payroll taxes.
The following are types of section 125 plans:
Full-flex cafeteria plan
With a full-flex cafeteria plan, employers make a non-elective contribution for each eligible employee.
Employees can spend the employer contribution to purchase any of the qualified benefit offerings within the cafeteria plan.
The employee may also contribute pre-tax money to buy additional benefits outside of what they can purchase with the employer's contribution.
Simple cafeteria plan
Employers with less than 100 employees may qualify for a simple cafeteria plan, under which the nondiscrimination requirements of a full-flex cafeteria plan are treated as satisfied.
A plan qualifies as a simple cafeteria plan if it meets specific contribution, eligibility, and participation rules.
Premium-only plan (POP)
POPs are one of the most common types of section 125 plans. A POP allows employees to pay their health insurance premiums with tax-free dollars.
As the name suggests, these premiums are the only expense funds can cover. The premiums can be for employer-sponsored insurance plans or individual health policies.
A POP can include a “cash-in-lieu of benefits” provision. Employees enrolled in another group health plan, like a spouse’s plan, can choose to receive a fixed amount of cash instead. With this option, the cash amount is taxed.
Flexible spending account (FSA)
An FSA is a savings account allowing employees to make tax-free contributions to pay for healthcare costs.
Another type of plan is a dependent-care FSA which pays for certain dependent care expenses, like costs for children under the age of 12 and qualifying adults that need assistance, like elder care.
As with most benefits, employees aren’t obligated to participate in a section 125 plan. Some employees may choose to receive their full standard wage. However, setting aside pre-tax money to pay for benefits is an appreciated perk for many individuals.
Who can participate in a section 125 plan?
Now that you know more about section 125 plans, let’s examine their participation requirements. Only employers can sponsor a section 125 plan; the plans are available to eligible employees, their spouses, and their dependents.
Depending on the plan design, section 125 plans may also include former employees, but the plan can’t exist primarily for them.
Any company with employees subject to income taxes in the U.S. can sponsor a section 125 plan, including a:
- Limited liability company (LLC)
- Sole proprietorship
- Government entity
However, certain people are excluded from participating in section 125 plans. These include self-employed individuals, partners within a partnership, and shareholders who own more than 2% of a subchapter S-corporation.
How much does a section 125 plan cost?
Setting up plan documents and necessary forms for your section 125 plan through an attorney or tax advisor typically costs between $100–$600, depending on your third-party administrator (TPA), broker, or tax advisor. But in comparison to the significant long-term tax savings under the plan, the initial fee is minimized.
A broker or TPA can help you stay on top of updates and regulatory changes that may affect your plan documents. It’s worth the cost to have ongoing assistance to handle any amendments to your plan if you need to bring it up to date with the most current regulations so you can stay in compliance.
How do you set up a section 125 plan?
Creating and maintaining your cafeteria plan benefit requires careful ongoing care. But there are a few tips that can get started.
Starting a section 125 plan requires following these three simple steps:
- Complete the required plan documents.
- Notify employees that you are offering a Section 125 cafeteria plan.
- Hire a TPA to administer your Section 125 plan and process reimbursements.
Once you start offering your section 125 plan, you must undergo nondiscrimination testing annually. All your test results should be kept on file in case of an audit.
Your organization’s plan must pass the following three nondiscrimination tests:
- Eligibility: Your plan design can’t make it easier for your company’s highest-paid key employees to participate.
- Benefits and contribution: Similar to eligibility, the benefits and contributions you offer must equally favor employees of all compensations.
- Concentration: The value of the benefits provided to your key employees must be at most 25% of the value of all your employees’ benefits.
What is a health benefit alternative to section 125 plans?
If a section 125 plan doesn’t seem like the right fit for your organization, you have other benefit options. Health reimbursement arrangements (HRAs) are a simple and flexible way for employers of all sizes to offer their employees pre-tax benefits by reimbursing them for their out-of-pocket medical needs.
Unlike section 125 benefits, HRAs aren’t pre-funded accounts and they’re only funded by employers. The money stays with the employer until the employee submits proof that an eligible item has been purchased. Once the expense is verified, the employee is reimbursed. Also, like FSAs, HRA funds stay with the employer if the employee leaves the organization, so the financial risk to the employer is lower.
Whether you’re offering a qualified small employer HRA (QSEHRA) or an individual coverage HRA (ICHRA), when it comes to premiums, you have two main options for setting up your plan: premium-only and premium-plus.
Let’s go over each plan type in more detail to help you decide which is best for you and your employees.
A premium-only HRA is similar to a section 125 POP—it’s an employer-only funded HRA that only reimburses employees for their qualifying insurance premiums and nothing else. This generally includes health insurance policies that qualify as minimum essential coverage (MEC).
Employers can also choose if they want to reimburse employees for their spouse’s employer-sponsored group insurance premiums. If so, this reimbursement will be taxable because the employee’s spouse is likely already making a payroll deduction on a pre-tax basis.
A premium-only HRA is best for you if:
- You want to contribute to your employees’ healthcare, but don’t have the budget to cover out-of-pocket expenses.
- You have a lot of employees on individual health insurance.
- You have a lot of employees with multiple health insurance premiums (i.e. health, dental, and vision).
It’s important to note that if you’re considering offering a premium-only HRA for budgetary reasons, simply lowering your HRA benefit allowance amount is another alternative.
That way, your employees are still free to choose how to spend their allowance, such as if they’d rather get reimbursed for out-of-pocket expenses, while you can still stay within your benefits budget.
A premium-plus HRA is an HRA that reimburses employees for the same qualifying health insurance premiums as a premium-only plan while also reimbursing employees for eligible, qualified expenses. All expenses outlined in IRS Publication 502 are reimbursable with a premium-plus HRA.
A premium-plus HRA is best for you if:
- You have a lot of employees on a spouse’s or parent’s plan, therefore they don’t need their own health insurance premiums reimbursed.
- You have a lot of employees that choose to be uninsured.
- You have the budget to reimburse more than just health insurance premiums.
If you’re already offering your employees a group health insurance plan, but also want to cover the out-of-pocket costs that aren’t fully paid for in the group plan, then the integrated HRA, or group coverage HRA (GCHRA), is for you.
An integrated HRA is the only HRA that exclusively covers out-of-pocket costs, not health insurance premiums, making it the perfect choice for employers looking to supplement their group health insurance plan.
With an integrated HRA, employees can get tax-free reimbursements for the qualifying expenses they must pay for before they meet their deductible, or for expenses that aren’t fully paid for by the group plan.
Employees today consider having access to flexible health benefits that improve their and their families' wellbeing a top priority. Section 125 plans remain popular because they allow employers to offer qualified benefits that attract and retain talent while reducing tax liabilities for themselves and their employees. But they may not be for everyone, and we understand that—that’s where HRAs come in.
Choosing between a premium-only or premium-plus HRA is one of the many ways you can customize your health benefit to suit your needs. With PeopleKeep, you can even have your HRA administered for you, so you don’t have to worry about handling documentation and staying in compliance. Schedule a call with us today to set up an HRA for your organization.
This article was originally published on January 27, 2015. It was last updated on June 17, 2022.