A Section 125 plan, also known as a cafeteria plan, allows employees to pay for certain benefits on a pretax basis. Employers use these plans to provide their employees with a choice between cash (a taxable benefit) and certain qualified benefits (such as health insurance) without adverse tax consequences.
According to the IRS, a Section 125 plan is the only means by which an employer can offer employees a choice between certain taxable and nontaxable benefits without the choice causing the benefits to become taxable. Employers may also make nontaxable contributions to a Section 125 plan for their employees.
Paying for benefits on a pre-tax basis:
- Reduces the employee’s taxable income, which increases their take-home pay
Reduces both the employee’s and employer’s tax liability
To receive these tax advantages, a cafeteria plan must comply with the specific requirements and regulations of Section 125 of the Internal Revenue Code (Code).
Tax Rules
Employees who elect to participate in a Section 125 plan agree to contribute a portion of their salaries on a pre-tax basis to pay for the qualified benefits. These contributions, which are called “salary reduction contributions,” are not considered wages for federal income tax purposes and are generally not subject to Social Security and Medicare tax (FICA) or federal unemployment tax (FUTA). This reduces employees’ taxable income, which results in savings for both employees and employers. If the employee elects to receive cash instead of any qualified benefit, the cash is treated as wages subject to all employment taxes.
What This Guide Covers
This guide provides answers to common questions regarding cafeteria plans, including the following:
- Who can sponsor a Section 125 plan, and how are they implemented?
- What types of Section 125 plans can be offered?
- Who is eligible to participate in a Section 125 plan?
- What are the advantages and disadvantages of participating in a Section 125 plan?
- What benefits can be offered under a Section 125 plan?
- What nondiscrimination rules apply to a Section 125 plan?
Why This Guide Is Helpful
This guide is intended to help employers understand why Section 125 plans are necessary and how they work. It provides detailed information on cafeteria plan design and other requirements of Internal Revenue Code Section 125. Employers should have their plan designs analyzed by qualified specialists to ensure full compliance with these rules, including when they perform cafeteria plan nondiscrimination testing.
Additional Resources
- IRS Publication 15-B, Employer’s Tax Guide to Fringe Benefits (contains information for employers on the employment tax treatment of fringe benefits, including cafeteria plans)
- Final regulations on Section 125 permitted election changes
- IRS Notice 2014-55, which expanded the mid-year election change rules in response to the Affordable Care Act (ACA)
- IRS Notice 2022-41, which expanded the mid-year election change rules to allow family members to enroll in ACA Exchange coverage
- 2007 proposed regulations on cafeteria plans, upon which taxpayers may rely
This guide is not intended to be exhaustive nor should any discussion or opinions be construed as legal or tax advice. Readers should contact legal counsel or tax professionals for legal or tax advice.
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