Section 125, or “Cafeteria” plans, are a vehicle for employers to offer certain benefits to employees on a tax-free basis. These plans are named after the section of the Internal Revenue Code (IRC) that regulates such arrangements.

Employees enrolled in Section 125 plans can reserve part of their pretax cash earnings to cover the costs of qualified benefits such as medical and childcare expenses. The benefit of setting this money aside is that employees can save up to 30 percent on local, state, and federal taxes. At the same time, when adopting a Section 125 plan, employers can see annual savings of up to $700 per employee.

Not only does a Section 125 plan provide significant savings for the company, but it also provides savings on health and childcare costs for your employees. This is an important incentive in acquiring new personnel and retaining your current team.

Setting Up a Section 125 Plan

To set up a Section 125 benefits plan in compliance with IRS requirements1, your employer will need to draft a document that outlines the benefits offered, contribution limits, participation rules, and other information required by the IRS. They may also have to perform non-discrimination tests, depending on the plan, to ensure that your plan doesn’t favor highly compensated or key employees.

Participating employees will need to sign a salary reduction agreement, which allows them to contribute a portion of their pre-tax salary to pay for the selected benefits.

Typically, with all the intricacies involved, many employers enlist the help of a third-party administrator such as Health Sphere to set up and manage their cafeteria plan.

Requirements and Eligibility

According to the IRS,1 any employer with employees who are subject to U.S. income taxes is eligible to sponsor a Section 125 plan. Employers can be C corporations, S corporations, LLCs, partnerships, governmental entities, or sole proprietorships.

Further, the IRS requires the following nondiscrimination requirements:

• Eligibility test. The plan must not discriminate in favor of highly compensated individuals regarding eligibility to participate in the plan.
• Benefits and contributions test. The plan must ensure that highly compensated participants do not select more nontaxable benefits than non-highly compensated participants.
• Key employee concentration test. The plan must not allow key employees to receive nontaxable benefits in excess of 25 percent of the total nontaxable benefits provided to all employees under the plan.

The IRS also established the following eligibility criteria:

• Eligibility and participation requirements. Employers must allow employees with at least 1,000 hours of service in the preceding plan year to participate in the plan and elect any benefit available under the plan, with limited exception.
• Contribution requirements. Employers must make benefit contributions for each qualified employee—one who is not a key employee or highly compensated—in an amount equal to one of the following:
  • A uniform percentage (not less than 2 percent) of the employee’s compensation for the plan year.
  • The lesser of at least 6 percent of the employee’s compensation for the plan year or twice the employee’s salary reductions. If this option is used, the rate of contribution to a highly compensated or key employee’s salary reduction cannot be greater than the rate of contribution to any other employee.2

How to Calculate Section 125 Benefits

In compliance with IRS regulations and while some practices may differ from company to company, employers who offer Section 125 plans generally process payroll as follows:

• Calculate employee gross earnings for the pay period
• Deduct contributions to section 125 cafeteria plans from gross income
• Withhold the applicable federal, state, and local taxes from taxable income
• Calculate employer tax liabilities for FICA, federal, and state unemployment
• Remit all payments to insurance providers and government agencies

These steps can be greatly simplified by working with our team of experts at Health Sphere. We can guide you through the entire process of establishing and managing your Section 125 plan.

Maintaining Compliance

Because of the tax-favored treatment when sponsoring a Section 125 plan for employees, there are significant rules employers must comply with. 

Employers must ensure their plans comply with IRS rules.1 Contributions must be properly deducted and documented to avoid issues with tax reporting. Coverage options, like health insurance premiums or HSAs, must meet eligibility criteria to qualify for tax advantages.

We Can Help

Choosing the right Section 125 plan, implementing it in your company, training HR personnel in how to administer the plan, calculating the benefits, and managing compliance can be complicated, to say the least. At Health Sphere, our team stands ready to provide you with plans that offer the best benefits for your company and guide you through the entire process. Find out how much your business can save today!

Sources:

1 Internal Revenue Service, Introduction to Cafeteria Plans,  Internal Revenue Service, Section 125 – Cafeteria Plans

2 SHRM, Society for Human Resource Management, Understanding Section 125