In today’s hiring market, companies have to spend more and more to create benefits packages that both attract and retain talent. A great solution to curb those expenses and, at the same time, receive significant savings on payroll taxes and health benefits, is the Section 125 plan, also called the “Cafeteria” plan, because employees can choose their options as these fit their needs.
What is a Section 125 Plan?
Section 125 of the IRS code1 offers an employer-sponsored benefit plan that allows employees to choose from a variety of pre-tax benefits, effectively reducing their taxable income.
Benefits covered by this plan can include options like insurance, retirement, health savings accounts (HSAs), childcare, and more. Employees can choose from several options based on their requirements and preferences, or choose not to take any benefits.
A Section 125 plan allows employees to allocate a portion of their salary pre-tax to pay for qualified benefits, which are not considered wages for federal income tax purposes and therefore not taxable. For employers, this can result in annual tax savings of up to $700 per employee.
Requirements
Any employer subject to US income taxes can sponsor a Section 125 plan. This includes sole proprietorships, partnerships, LLCs, C corporations, and S corporations. At the same time, the IRS has issued strict requirements for employers to establish a Section 125 plan in their company:
- To qualify, the plan must be set up by an eligible employer and offer only IRS-approved benefits.
- The IRS also requires that contributions be deducted before taxes and are calculated on payroll. Employers must track these deductions accurately to avoid issues with payroll taxes, Social Security, and Medicare. If a plan doesn’t follow guidelines, it could lose its tax-free status, leading to potential penalties.
- Your Section 125 plan cannot favor your company’s highest-paid employees or executives.
- The benefits you offer with your Section 125 plan must favor employees of all compensation equally.
- The plan must not allow key employees to receive nontaxable benefits above 25 percent of the total nontaxable benefits provided to all employees under the plan.
Important Considerations
When considering Section 125 plans, it is important to keep in mind that although these plans offer benefits, there are also limits. One such limitation is the “use it or lose it” rule that applies to FSAs. This means that your employees will lose any unused funds at the end of the plan year or grace period.
It’s also important to know that employees themselves cannot change Section 125 benefits elections unless they experience a qualifying life event, like marriage, divorce, the birth of a child, change of residence, or change of employer, etc. This means they’re locked into most choices for an entire calendar year, even if their needs may change during that year.
How to Set Up Your Section 125 Plan
When setting up a section 125 cafeteria plan, HR professionals should consider several key elements to ensure compliance and effective implementation. The following steps will help you establish a Section 125 plan:
1. Determine eligibility
Determine which employees are eligible to enroll in your plan. In most cases, eligibility is linked to defined criteria, like employment status or time worked. For example, partners within a partnership and shareholders who own more than 2% of a subchapter S corporation are not eligible.
2. Get all the required documentation prepared for the IRS
The IRS requires documentation that outlines the terms and conditions of your plan. It should include details of the benefits you’re offering, eligibility requirements, enrollment procedures, employee contribution amounts, and limits, and any additional documentation required by the IRS.
3. Verify your documentation does not violate discrimination rules
Non-discrimination tests may be necessary to ensure that your plan meets IRS requirements. These tests may include an eligibility test, a benefits and contributions test, and a test to confirm that your plan does not favor highly compensated employees and requires that all participants have an equal opportunity to benefit from the plan.
4. Adjust your payroll
Your payroll system will need to be adjusted to ensure the proper employer and employee benefits and contributions are made and taxes are correctly calculated.
5. Notify your employees
Notify all eligible employees about the plan’s availability and provide enrollment information. Answer questions and make sure they understand the benefits and requirements.
6. Regularly review and update documents
After implementing your plan, make sure your company stays compliant with any changes to IRS regulations and updates your plan documentation where needed to reflect any changes in the benefits you offer.
When in Doubt, Get Help
Setting up and managing section 125 plans can be difficult and time-consuming. Our team at Health Sphere is available to help you choose the right plan, implement and oversee your plan, and any other functions required to get your plan smoothly integrated into your company. Learn more about how we can assist you today!
Sources:
Internal Revenue Service, Introduction to Cafeteria Plans,
Internal Revenue Service, Section 125 – Cafeteria Plans
