A Section 125 or “Cafeteria” plan is part of the IRS code that enables employees to take taxable benefits, such as a cash salary, and convert them into nontaxable benefits. Employees enrolled in Section 125 plans can reserve part of their pre-tax 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.
From a financial and personnel retention viewpoint, these are important benefits for the growth and stability of your company.
How Does a Section 125 Plan Work?
To engage in a Section 125 plan for your employees, you must employ an average of 100 or fewer employees during either of the preceding two years.
Your employees can opt to have money deducted from their gross earnings to pay for qualified benefits, such as health insurance premiums, health flexible savings accounts (FSAs), health savings accounts (HSAs), or dependent and childcare assistance programs (DCAPs). These deductions not only decrease the employee’s taxable income but also reduce your company’s payroll tax liabilities.
Because your employees have opted to deduct money from their gross wages, no federal income tax is taken on these earnings. At the same time, your company also benefits from setting aside wages for Section 125 use, since employer payroll taxes collected through the Federal Insurance Contributions Act (FICA) and Federal Unemployment Tax Act (FUTA) are not taken on these funds.
Benefits of a Section 125 Plan
Cafeteria plans offer some significant benefits both for your company and for your employees:
- Less taxes for employees: Employees will pay less in taxes because the money you put towards their Section 125 plans isn’t taxed as normal income.
- More money for out-of-pocket expenses: If you put $5,000 aside for an employee’s Section 125 plan, your employee enjoys a tax-free $5,000 they can use to cover out-of-pocket expenses. If you paid out this sum as part of their regular salaries instead, they would lose some of this money (often a double-digit percentage) to taxes.
- Less taxes for employers: Your company doesn’t have to pay FICA or FUTA taxes on employee wages set aside for Section 125 purposes. That means that you can reduce your business’s tax liability.
At the same time, there may be some drawbacks to a Section 125 plan:
- Use it or Lose it: Participants who put funds into a Section 125 plan must use those funds during the plan year; otherwise, those funds will be lost.
- Upfront Payments: Employees are reimbursed for expenses as part of a health flexible spending account. This means expenses must be paid out-of-pocket first and are reimbursed after a claim is made. This may be a burden for some employees.
- Setup Fees: There is an initial Section 125 plan setup fee for your company. You may want to consider the fee as a one-time investment that could provide significant long-term savings later on.
Types of Coverage
There are a number of different Section 125 plans, each with its own unique coverage. Just like in a cafeteria, your Section 125 plan allows employees to pick benefits from a variety of choices. Any costs beyond the maximum your company will pay then become the responsibility of the employees, paid for via payroll deductions throughout the year.
According to Section 125 of the Internal Revenue Code, cafeteria plans can cover the following qualified benefits:
- Accident and health benefits
- Dependent care assistance plans (DCAPs)
- Adoption assistance
- Group-term life insurance
- Health savings accounts (HSAs)
Setting Up a Section 125 Plan
Setting up a Section 125 plan is pretty straightforward. The setup steps include:
- Complete and provide the necessary plan documents.
- Notify employees that you are providing a Section 125 cafeteria plan.
- Hire a third-party administrator to manage your Section 125 plan and process reimbursements.
Additionally, Section 125 plans must pass three nondiscrimination tests that are designed to determine eligibility to participate (your plan does not discriminate in favor of highly compensated or key employees of your business), benefits and contributions, and concentration tests.
Typical third-party administrators provide employers with an up-to-date plan document, summary plan descriptions, corporate resolution, customized forms, legal review, attorney opinion letters, discrimination testing, a signatory-ready Form 5500 if required, and employee education.
We Can Help
If you are looking to explore the savings and advantages of a Section 125 Plan, Health Sphere is ready to assist you. Our PCMP program simplifies the process, ensuring compliance and ease. Find out how much your business can save today!
