About the Section 125 (or Cafeteria) Plan

Across the U.S., numerous employers set up and use various types of employee benefits plans allowed by the Internal Revenue Service (IRS). One of these plans, called a Section 125 (or cafeteria) plan, has been in existence since 1978 and offers some interesting advantages. 

What Is a Section 125 (or Cafeteria) Plan?

A Section 125 plan is part of the IRS code that enables and allows employees to take taxable benefits, such as a cash salary, and convert them into nontaxable benefits. These benefits may be deducted from an employee's paycheck before taxes are paid. Cafeteria plans are particularly good for participants who have regular expenses related to medical issues and child care.

Employees enrolled in a Section 125 plan can set aside insurance premiums and other funds pretax, which can then go toward certain qualified medical and child care expenses. Depending on where they live, participating employees can save from 28% to 48% in combined federal, state, and local taxes on a variety of items that they typically already purchase with out-of-pocket post-tax funds. Employers can save an additional 7.65% on their share of payroll taxes. 

Who Can Open a Section 125 Plan?

Section 125 plans must be created by an employer. When a plan is created, the benefits are available to employees, their spouses, and their dependents. Depending on the circumstances and details of the plan, Section 125 benefits may also extend to former employees, but the plan cannot exist primarily for them.

Benefits to Employer and Employee

On the employer side, Section 125 plans offer lots of tax-saving benefits. For each participant in the plan, employers save on the Federal Insurance Contributions Act (FICA) tax, the Federal Unemployment Tax Act (FUTA) tax, the State Unemployment Tax Act (SUTA) tax, and workers' compensation insurance premiums. Combined with the other tax savings, the Section 125 plan usually funds itself because the cost to open the plan is low.

As an added advantage, employees receive an effective raise without any additional cost to the employer. Because more participants in the plan equate to more tax savings for the employer, the employer is often encouraged to contribute to each employee's plan to promote increased participation by those not yet in the Section 125 plan.

As for employees, the primary benefit is also tax-related. Typically, a participant can expect to save 20% to 40% of every dollar put into the plan. The amount that the employee decides to put into the plan must be chosen each year. The "election" amount is deducted from the employee's paycheck automatically for each payroll period.

For example, if an employee elects to have $600 per year deducted from their pay and placed into the plan and the company has 24 pay periods, then $25 per pay period is automatically deducted tax-free. The money is sent to the plan's third-party administrator to be held. It can then be distributed for reimbursement upon request for qualified expenses.

What Expenses Can a Section 125 Plan Cover?

A wide variety of medical and child care expenses are eligible for reimbursement under a Section 125 plan. As for medical items and treatments, dozens of eligible expenses can be reimbursed.

Eligible expenses include acupuncture, treatment for alcoholism, ambulance services, birth control, chiropractic services, dental and doctors' fees, eye exams, fertility treatment, hearing aids, long-term care services, nursing homes, operations, prescription drugs, psychiatric services, sterilization, wigs, and wheelchairs.

There are also a large variety of eligible over-the-counter items. Allergy medicines, cold medicines, contact lens solutions, first-aid kits, pain relievers, pregnancy tests, sleeping aids, and throat lozenges are among the dozens of eligible items. Many dual-purpose items are eligible, such as dietary supplements, orthopedic shoes, prenatal vitamins, and sunscreen.

Use It or Lose It

Section 125 plans do state you must use any remaining funds in the account by the end of the year or the money is forfeited to your employer. A carryover provision, implemented in 2013, does allow plan participants to extend up to $500 of unused funds from one year to the next.

Even if you do get dinged by an excess amount of funds, contributing to a cafeteria plan may still result in a net benefit. Assume that you placed $1,000 in your Section 125 plan. At the end of the year, you notice that you have $100 remaining in the account. If you are in the 24% marginal tax bracket, you have already saved $240 on taxes ($1,000 x 24%). Forfeiting the $100 means that you still have a net benefit of $140.

Setting Up a Section 125 Plan

Setting up a Section 125 plan is straightforward. An employer needs to provide proper documentation, notify employees, and perform nondiscrimination testing. Section 125 plans must pass three nondiscrimination tests designed to determine if the plan discriminates in favor of highly compensated or key employees of the business: eligibility to participate, benefits and contributions, and concentration tests.

Cafeteria plans have different levels of benefits. A premium-only plan (POP) allows employees to pay their portion of insurance on a pretax basis. The flexible spending account (FSA) version allows for out-of-pocket qualified expenses to be paid pretax, which is the style of the plan described above.

The full-blown plan is called a consumer-driven healthcare (CDHC) plan and involves a credit system the employee can use on a discretionary basis for qualified expenses. Employees can then supplement the CDHC with their own money and use it to buy additional benefits or coverage.

Employers must hire and partner with a qualified Section 125 third-party administrator, who can provide the most up-to-date documentation for setting up a plan and update the employer on the latest requirements necessary for compliance. Typical third-party administrators provide employers with an up-to-date plan document, summary plan descriptions, corporate resolution, any customized forms, legal review, attorney opinion letters, discrimination testing, a signatory-ready Form 5500 if required, and employee education.