What is a Section 125 plan? The short answer

A Section 125 plan is a written plan that lets your employees pay for certain benefits before tax instead of after. That is the whole idea. The name comes from the section of the tax code that allows it, and the nickname "cafeteria plan" just means employees choose from a menu of benefits.

Everything else you will hear about Section 125, the payroll tax savings, the wellness plans, the vendor pitches, sits on top of that one sentence.

What a Section 125 plan can hold

The menu is limited by law. The common items are:

• Premium-only plan (POP). Employees pay their share of health, dental, and vision premiums pre-tax. This is the simplest version and the one most small companies mean when they say they "have a 125 plan."
• Health FSA. A flexible spending account for medical expenses, funded pre-tax up to the annual IRS limit.
• Dependent care FSA. The same idea for child and dependent care costs.
• HSA contributions. Employee contributions to a health savings account can run through the plan pre-tax.

Things that do not belong in a cafeteria plan include most life insurance above a small amount, long-term care, and anything that pays cash back to the employee without a documented expense. That last one matters, and the pros and cons go into why.

What has to exist on paper

A plan is not a payroll setting. It is a document. To be a Section 125 plan at all, you need:

1. A written plan document adopted before the plan year starts.
2. A defined plan year.
3. Eligibility rules that do not favor owners and highly paid employees.
4. Election rules, including when someone can change an election mid-year.

If you are deducting premiums pre-tax and cannot find those four things, you do not have a plan yet. You have pre-tax deductions with nothing behind them, which is the most common problem we see, and the IRS can treat those deductions as taxable wages.

Where the savings come from

When an employee elects a benefit pre-tax, that money leaves the wage base. The employee stops paying income tax and their 7.65% share of FICA on it, and the employer stops paying its 7.65% share too. The savings are real and modest per person, and they add up across a company. If someone quotes you a number several times larger than that arithmetic, they are describing a different plan design, and you should read what to watch out for before you sign anything.

Who cannot participate

Owners of more than 2% of an S corporation, partners in a partnership, and members of an LLC taxed as a partnership cannot participate, and neither can their spouses, parents, or children. They can sponsor the plan for their employees; they just cannot join it. Sole proprietors are in the same position. That rule surprises a lot of owners after the fact, so it belongs at the front of any conversation with a vendor.

Educational only, not tax or legal advice. Confirm anything you rely on with your CPA.