Section 125 – Cafeteria Plans Overview

A Section 125 plan, or a cafeteria plan, allows employees to pay for certain benefits on a pre-tax basis. Specifically, employers use these plans to provide their employees with a choice between cash and certain qualified benefits without adverse tax consequences. Paying for benefits on a pre-tax basis reduces the employees’ taxable income and therefore reduces both the employees’ and the employer’s tax liability.

In order to receive these tax advantages, a cafeteria plan must comply with the rules of Internal Revenue Code (Code) Section 125 and related Internal Revenue Service (IRS) regulations. Under these rules, a Section 125 plan must have a written plan document and can only offer certain qualified benefits on a tax-favored basis. While self-employed individuals may maintain a Section 125 plan for their employees, only common law employees may participate in the plan.

In addition, once an employee makes a Section 125 plan election, he or she may not change that election until the next plan year, unless the employee experiences a permitted election change event. Also, in order for highly compensated employees to receive the tax advantages associated with a Section 125 plan, the plan must generally pass certain nondiscrimination tests.

 

Cafeteria plan basics

Code Section 125 allows employers to establish a type of tax savings arrangement, called a Section 125 plan or cafeteria plan, for their employees. A Section 125 plan provides employees with an opportunity to pay for certain benefits on a pre-tax basis, allowing them to increase their take-home pay. Employers may also make nontaxable contributions to a Section 125 plan for their employees.

Under a Section 125 plan, employees choose between at least one taxable benefit (such as taxable compensation) and one or more qualified benefits. Qualified benefits include, for example, the following commonly offered employee benefits:

• Group health plans;

• Vision and dental plans;

• Disability and life insurance;

• Health flexible spending accounts (FSAs)

• Dependent care assistance programs (DCAPs)

• Health savings account (HSAs).

According to the IRS, a Section 125 plan is the only means by which an employer can offer employees a choice between taxable and nontaxable benefits without causing adverse tax consequences to the employees. To avoid taxation, the Section 125 plan must meet the specific requirements of Code Section 125 and underlying IRS regulations.

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 a savings for both employees and employers.

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