A section 125 cafeteria plan is a benefits plan that resembles a menu of options for your employees to choose from. It’s nicknamed a “cafeteria plan” because an employee can choose between medical, dental, vision, and other employee benefits, or opt to receive the same amount in cash. Once a section 125 plan is understood, it can be a great way for a small business owner to offer benefits while also getting a tax break.
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What Is a Section 125 Cafeteria Plan?
A cafeteria plan is an employee reimbursement style benefits plan that meets the specific requirements of Section 125 of the Internal Revenue Code of the IRS. The main thing about a section 125 plan is that employees receive the same amount of money allocated to them, regardless of whether they apply it towards health-related benefits (on a pre-tax basis) or receive it as part of their taxable salary, such as by cash or another taxable benefit (like supplemental disability or life insurance that’s above basic coverage).
Let’s be clear- a section 125 plan is NOT providing health insurance. If you want to provide health insurance, check out our full guide here.
The section 125 requirements include:
- The plan’s benefits are offered a pre-tax basis, meaning employees can pay their health premiums, retirement deposits, or other benefit options using non-taxed wages through their employer’s section 125 reimbursement account.
- The plan has to include at least one taxable benefit option, which means the government views it as part of the employee’s salary. An example of this is allowing employees to instead take the monthly amount as cash into their salary (over using it towards the benefit plan).
- The plan also must include at least one qualified benefit, which means it is excludable from an employee’s gross income under a specific provision of tax law, meaning it is pre-tax. Qualified benefits include:
If this all sounds intimidating- don’t let it be, and keep reading. The benefits to an employer using a section 125 plan are great, albeit a bit complicated to understand.
Section 125 vs A Traditional Employer-Provided Insurance Plan
To make things a bit easier to understand, we thought an example of a cafeteria plan versus a traditional employer-provided insurance plan would be helpful:
In a traditional insurance employer-provided insurance plan, the employer covers all (or part of) their employee’s premiums. If an employee decides they do not need health insurance — say, if they’re already covered by a spouse’s plan — they do not get the allocated amount put towards other benefits, or towards their own salary as cash.
With a section 125 cafeteria plan, your employee can receive the allocated amount as cash, or use it towards another benefit. Just bear in mind, if it’s used towards salary, the amount will be taxed at the employee’s usual salary rate.
Benefits Typically Included in a Section 125 Cafeteria Plan
Here’s what you need to know about the 3 benefits that make up a section 125 cafeteria plan. Note that you can implement just one of them, a combination of them, or all 3 of them for your cafeteria plan.
1. Pre-tax health insurance premium deductions, aka Premium Only Plan (POP).
POP plans allow employees to decide to set aside a portion of their pre-tax salary to pay for their health insurance premium contribution for most employer-sponsored health insurance plans, like HMOs, PPOs, and POS plans through health insurance carriers. A POP plan is the simplest type of Section 125 plan and is easy to rollout and maintain.
Health savings accounts (HSAs) fall under this category as well, and can represent a kind of POP module. The HSA is a pretty complicated set up since it’s tied to a High Deductible Health Plan (HDHP), so many employers avoid having an HSA in their cafeteria plan.
2. Flexible spending account (FSA).
An FSA allows an employee to pay for certain medical expenses on a pre-tax basis. Effectively the employee pays for out-of-pocket expenses that aren’t covered by insurance with dollars set aside in an account. If the FSA is the only benefit provided, it can also be used to reimburse employees for money they spend on health insurance premiums. Read more about FSAs here.
3. Dependent Care Assistance Plan (DCAP) FSA.
The Dependent Care Assistance Plan (DCAP) FSA is a benefit for employees who pay for childcare or adult care for their parents. Employees may hold back as much as $5,000 annually of their pre-tax salary for DCAP, including expenses they pay while they work, look for work or attend school full time. Qualified expenses may include the care of a child under the age of 13, daycare for parents, care for a disabled family member, and summer day camps.
Who Can Provide You A Section 125 Plan
If this sounds pretty complicated, we have good news. All of the following 3 options can provide you with a cafeteria plan and make sure you are compliant:
- A Professional Employer Organization (PEO) buyer’s guide – becoming part of a PEO can be a great way to offer a cafeteria plan as a small employer.
- HR software like ADP Total Source
- An individual private insurance broker or a large insurance company like Aflac
Although a PEO is a simpler and more hands off approach, the provider essentially becomes a co-employer of your team. If you’re in the market for a PEO, ADP TotalSource is a trusted solution that lets you offer employees Fortune 500-caliber benefits and manage critical HR tasks with fewer headaches. Contact them for a free quote.
Cafeteria Plan Must Haves
To be compliant, your section 125 cafeteria plan must have a number of things included. This is why we recommend using a professional, like a PEO, insurance broker, or HR software, in order to make sure your section 125 plan is compliant.
1. A plan document.
This document outlines specific details, such as a description of the employee benefits that are covered through the plan, participation rules, annual limits, election procedures, eligibility and employer contribution. It also defines the plan year.
2. A summary plan description (SPD).
The SPD summarizes specific details of the plan, claim filing procedures, and information concerning plan sponsorship and administration. In addition to distributing it to your employees and their beneficiaries, you must also file it with the Department of Labor within 120 days of the plan’s effective date. You can read more from the IRS here.
3. Ongoing compliance.
The laws are constantly changing. Federal legislation requires that section 125 plans can’t discriminate as to eligibility and benefits being provided, which is especially important if you have a wide range of compensation among your employees. The plan can’t be biased towards the higher earners.
This is why we heartily recommend working with a licensed benefits provider, be it a broker or an insurance company, to execute a cafeteria plan in order to maintain compliance.
The Pros & Cons of a Section 125 Cafeteria Plan
To make a cafeteria plan a bit more understandable, we are going to focus this section on the benefits and drawbacks of cafeteria plans.
Pros of a Section 125 Plan for the Employer
First, let’s look at the top 4 benefits to you as the small business owner of having a cafeteria plan:
1. Employers experience tax savings from reduced payroll taxes on participating employees.
FICA, FUTA, SUTA, and Workers’ Compensation rates are all lowered since your employees’ taxes are being lowered as well. These taxes and compliance elements can be taken care of via payroll software.
2. These above tax savings reduce or eliminate altogether the costs of offering the cafeteria plan.
Because you have reduced payroll taxes, your cost to setting up the plan is offset. Not to mention, you as the employer get to keep the money that’s not used in FSAs at the end of each year as a fund for the future years of the plan, reducing costs even more.
3. Both participating and nonparticipating employees reap the benefits.
The participating employees in a cafeteria plan get benefits of some kind, and the non-participating employees get cash. This makes everyone happy and can help to reduce turnover or attract new talent to apply to your company.
Cons to Cafeteria Plans
Every benefits plan has its downsides and a cafeteria plan is no different. From both an employer’s and employee’s perspective, the downsides to a section 125 plan are:
1. They are complicated to understand.
As you can see from this article, cafeteria plans take a moment to understand them. It is best that you use either an insurance company or a private insurance broker to help you set one up.
2. Your employees are locked into their designated contributions for 1 year and they cannot change this.
So, if Johnny and his wife have a baby or fall upon hard times and want to stop their contributions to the cafeteria plan, they can’t until the year period is up.
3. A Flexible Spending Account is a “use it or lose it” benefits commonly offered in a cafeteria plan.
Employees needs to be reminded that they will lose their Flexible Spending Account (FSA) dollars if they do not use them for qualified expenses within the year, which can be a headache for employers. They also cannot take them with them if they quit or are fired.
The Bottom Line
A section 125 cafeteria plan can be a great way for a small business owner to provide benefits while saving money and keeping their employees happy. However, we recommend that you work with a professional on how to do this, in order to do this correctly and to reap the benefits while staying compliant.