HR Mavericks

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Section 125 Cafeteria Plan
Section 125 Cafeteria Plan is a way in which your organization can offer employees a choice between taxable and nontaxable, without the choice being taxable. In this content we will discuss what a Section 125 plan is, and how your organization could benefit.

What Is a Section 125 Cafeteria Plan?

The Internal Revenue Services (IRS) defines a Section 125 plan as a cafeteria plan maintained for employees by an organization that meets the specific requirements and regulations of section 125 of the Internal Revenue Code. Section 125 plans provide participants of the plan the opportunity to receive certain benefits on a pretax basis. Per the IRS, participants (employees) in a cafeteria plan must be permitted to choose among at least one taxable benefit and one qualified benefit.

What Are the Benefits of Offering Section 125 Cafeteria Plans?

There are a number of reasons why organizations should consider offering a Section 125 plan, such as tax savings, reduced payroll liabilities and tax liabilities.
  • Tax savings. Contributions to a cafeteria plan are withheld on a pre-tax basis. Therefore these contributions are not considered wages for federal income tax or federal unemployment tax (FUTA). Both the employer and the employee benefit because taxable income is reduced.
  • Payroll and tax liabilities. Liabilities associated with payroll include but are not limited to compensation, paid time off and payroll taxes. Offering a Section 125 Cafeteria Plan lowers the taxable income, which means employees and employers pay less in federal income tax and Medicare and Social Security taxes.

Types of Section 125 Cafeteria Plans

There are a number of Section 125 Cafeteria plans. Here we review the most common.

Premium-Only Plan (POP)

Premium Only Plan (PoP) allows organizations to make a change in its payroll process to deduct the employee portion of employer-sponsored benefit premiums on a pre-tax basis. PoP provides employees the opportunity to pay their share of employer-sponsored premiums on a pre-tax basis, which allows an employer to cut payroll taxes and increase employees’ take-home pay.

Flexible Spending Account (FSA)

Flexible Spending Accounts (FSAs) provide pre-tax payroll deductions for certain medical and dependent care expenses. Organizations may opt to contribute to an employee’s FSA; however, it is not a requirement. There are two primary FSA categories:
  • Healthcare FSAs. A healthcare FSA (HFSA) is designed to assist with personal medical expenses. An HFSA allows an individual to set aside tax-free dollars to pay for specific medical costs.
  • Dependent care FSAs. A dependent care FSA (DCFSA), also known as a Dependant Care Assistance Plan, assists with dependent care expenses. The DCFSA is designed for employees who are responsible for dependent care.
As of January 2023, participants may contribute up to an annual maximum of $3,050 towards their HCFSA. If your organization’s plan permits rollover for unused HCFSA funds, the maximum carryover amount is $610. In addition, the DCFSA annual maximum contribution limits are $5,000 per household, or $2,500 if married filing separately. There are a few criteria that must be met if an employee decides to enroll in the DCFSA.
  • Qualifying dependent (QD) must live with the employee
  • QD must be 12 years old or younger, or a person who is 13 years old or older and qualifies as physically and/or mentally incapable of caring for themselves and spends at least eight hours a day in the employee's household
This type of FSA allows an employee to be reimbursed for eligible dependent care expenses so that the employee and his or her spouse may work, look for work or attend school full-time.

Health Savings Account (HSA)

Similar to an FSA, a health savings account (HSA) also helps employees pay for certain medical expenses. What differentiates this from an FSA is that it is a savings account that earns interest. An HSA provides multiple taxes advantages such as:
  • Funds added to the account are pre-taxed
  • Interest earned is not taxable
  • Funds used to pay for eligible health expenses are not taxed
To enroll in an HSA, the employee must be enrolled in a high-deductible health plan (HDHP), must have no other health insurance (exceptions may be applicable), or be enrolled in Medicare. As of 2023 employees may contribute up to $3,850 if they’re enrolled in self-only coverage or up to $7,750 for family coverage.

How to Implement and Manage a Section 125 Cafeteria Plan

There are a few simple steps an organization may take to implement a Section 125 plan and manage their plans. Organizations should consider consulting with an attorney and/or tax advisor when doing so.

Step 1: Documents

Section 125 plans are covered by the Employee Retirement Income Security Act (ERISA), which includes requirements for written plan documents. The IRS sets the plan document requirements. Organizations are required to provide written plan documents, including a master plan document, an adoption agreement (which can be included in the master plan document) and a summary plan description (SPD). This must be provided to all eligible employees within 30 days of becoming covered by the plan. Plan documents must include the following:
  • Plan year. Organizations may change their plan year; however, the change can only be made for valid business purposes such as aligning with the provider’s benefit year.
  • Annual election. The plan documents must include verbiage regarding elections. Elections are made annually and are irrevocable during the plan year. However, Section 125 regulations provide employers to allow for certain midyear changes due to changes in employee status, such as the birth of a child(ren). Permitted status changes must be listed in the employer's plan documents.
  • Other requirements. Eligibility rules, benefits available, plan trustee(s) and administrator(s) must be identified in an organization’s plan documents.
Plan documents must be in place prior to the first day of the plan year and do not include filing the document with government agencies.

Step 2: Non-Discrimination Test

When designing your plans, a non-discrimination test may be applicable. The purpose of a non-discrimination test is to ensure that it doesn’t favor highly compensated or key employees. This is applicable to both the benefit availability and benefit use. If it is determined during testing that the benefit being offered is discriminatory, the taxable benefit must be included in the gross wages of highly compensated employees.

Step 3: Communication

In this step, be sure to communicate to employees that your organization is offering a Section 125 plan(s). Consider educating your employees during onboarding, empowering managers and making the information easily accessible.

Mistakes and Pitfalls to Avoid With a Section 125 Cafeteria Plan

There are consequences that organizations may face due to non-compliance with Section 125 plan requirements. An employer may be held liable for claims against the plan if the documents do not give participants accurate information about plan policies. Pre-tax deductions may also be disallowed from the start of the plan, and the IRS may collect back taxes and interest, and impose financial penalties of $110 per day for failure to distribute SPD to participants within 30 days of the request. The Department of Labor may also impose a penalty of $100-$1,000 if the SPD is not provided within 30-days of the request.

Pitfall 1: No Plan Documents

Plan documents are required for all organizations, no matter the size. Many small to midsize organizations do not realize this is a requirement, therefore no documents are in place. Be sure you have your documents in place and review them regularly.

Pitfall 2: Authorization

Evidence of employees' authorizations to elect (or decline) benefits should be retained. The IRS allows for both written and electronic elections. Organizations should maintain systems for retaining employee authorizations and proof-of-eligibility documents required for status changes.

Pitfall 3: Non-Discrimination Test

Many organizations fail to conduct nondiscriminatory tests. These tests are required annually at the end of the plan year. It is recommended that interim testing be conducted to avoid any potential issues for organizations that provide for midyear changes. No matter the size or type of business, all employers must conduct a non-discrimination test if your organization offers plans that are maintained by Section 125.
Wendy N. Kelly, MSHRM, PHR, SHRM-CP

Wendy N. Kelly, MSHRM, PHR, SHRM-CP

Wendy is an HR professional with over 10 years of HR experience in education and health care, both in the private and non-profit sector. She is the owner of KHRServices, a full service HR management agency. She is also SHRM and HRCI certified, serves as a HRCI Ambassador, and voted 2021 Most Inclusive HR Influencer.
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