Many employers may find it challenging to provide a budget-friendly and attractive benefits package due to factors like rising healthcare costs. Thankfully, options like a section 125 plan, or cafeteria plan, allow you to boost your employee benefits while staying in-budget.
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 total compensation without any change in their taxable income.
In this article, we’ll take a comprehensive look at section 125 benefit plans to help you better understand how they work for employers and employees.
What is a section 125 plan?
A Section 125 plan is a plan defined under section 125 of the Internal Revenue Code that enables employees to take a taxable portion of their total compensation—such as their cash salary—and receive it as a qualified benefit on a pretax basis.
According to the IRS, the following qualified benefits are eligible under Section 125 plans1:
- 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. Employees participating in a Section 125 plan can—depending on their location—save between 28% to 48% in total federal, state, and local taxes on various benefits.
Because cafeteria plan contributions use pre-tax deductions, an employee’s overall taxable income decreases 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.
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 qualified benefit offering 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 fewer than 100 employees may qualify for a simple cafeteria plan, under which the nondiscrimination requirements of a full-flex cafeteria plan are 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 subject to taxes.
An FSA is a savings account allowing employees to make tax-free contributions to pay for healthcare costs.
Another plan type 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 have no obligation to participate in a section 125 plan. Some employees may choose not to exchange a portion of their taxable wages for tax-free benefits. 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.
Section 125 plans may also include former employees depending on the plan design, 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 minimal.
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 necessary 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. You should keep all your test results 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 contributions: 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 expenses.
Unlike section 125 benefits like HSAs, HRAs aren’t pre-funded accounts, and only employers may fund them. Unused funds 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 can only be used to cover an employees’ qualifying insurance premiums and nothing else. This generally includes health insurance policies that qualify as minimum essential coverage (MEC). The differences are that funds are only provided by the employer, and only on a reimbursement basis.
Employers can also choose if they want to reimburse employees for their spouse’s employer-sponsored group insurance premiums. If so, this reimbursement is seen as taxable income because the employee’s spouse is likely 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 costs.
- 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 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.
Another benefit option you have available is a premium-plus HRA. 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 healthcare costs that the group plan doesn’t fully cover, then the integrated HRA is for you.
An integrated HRA, or group coverage HRA (GCHRA), 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. They also don’t have minimum or maximum contribution limits, so you can offer an allowance that works best for your budget.
With an integrated HRA, employees can get tax-free reimbursements for any qualified expenses they 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 types of benefits that improve their and their families' health and wellbeing a top priority. Section 125 plans remain popular because they allow you to offer qualified benefits that attract and retain talent while reducing tax liabilities for you and your employees. But if they’re not for you, HRAs are a great alternative.
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, our software makes handling documentation and staying in compliance easy for employers who don’t have the time to deal with complicated administrative tasks.
This article was originally published on January 27, 2015. It was last updated on February 3, 2023.