What Is a Section 125 Cafeteria Plan?
A Section 125 cafeteria plan — named after the section of the IRS tax code that governs it — is a written employer plan that allows employees to choose between taxable cash compensation and certain non-taxable benefits. The most common application is allowing employees to pay their share of health, dental, and vision insurance premiums with pre-tax dollars.
Without a Section 125 plan, employees pay their benefit premiums with after-tax dollars. With a Section 125 plan, those same premiums are deducted from gross pay before federal income tax, Social Security tax, and Medicare tax are calculated — resulting in immediate tax savings for both the employee and the employer.
How Much Can You Save?
The savings are substantial. Consider an employee earning $50,000 per year who pays $3,000 annually in health insurance premiums:
| Scenario | Without Section 125 | With Section 125 |
|---|---|---|
| Annual Salary | $50,000 | $50,000 |
| Premium Payment | After-tax ($3,000) | Pre-tax ($3,000) |
| Taxable Income | $50,000 | $47,000 |
| Employee Tax Savings (est.) | — | ~$690/year |
| Employer FICA Savings (est.) | — | ~$230/year |
For a business with 20 employees, the employer's FICA savings alone can exceed $4,000 per year — at virtually no administrative cost.
What Benefits Can Be Included?
A Section 125 plan can include several types of benefits:
- Health insurance premiums (medical, dental, vision)
- Flexible Spending Accounts (FSAs) for healthcare and dependent care
- Accident and disability insurance premiums
- Group term life insurance (up to $50,000 in coverage)
- Adoption assistance
How to Set Up a Section 125 Plan
Setting up a Section 125 plan requires a written plan document that describes the benefits offered, eligibility rules, and election procedures. The plan must be adopted before the benefits are offered — retroactive adoption is not permitted by the IRS.
Once the plan document is in place, the employer notifies employees of their options during open enrollment. Employees make their benefit elections, and payroll is adjusted to deduct premiums on a pre-tax basis.
Common Mistakes to Avoid
- No written plan document: The IRS requires a formal written plan. Verbal agreements or informal arrangements do not qualify.
- Allowing mid-year changes: Elections are generally irrevocable for the plan year unless the employee experiences a qualifying life event.
- Including ineligible benefits: Not all benefits qualify for Section 125 treatment. Long-term care insurance, for example, is not eligible.
How MedHealth Can Help
MedHealth Insurance Agency helps Massachusetts businesses implement Section 125 plans as part of a comprehensive benefits strategy. We coordinate with your payroll provider to ensure seamless pre-tax deductions and provide employees with clear explanations of their tax savings. Our service is completely free to your business.