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Section 125 Plan Overview

Offer benefits on a pre-taxable basis to your employees.

Do You Need a Section 125 Plan?

If you are an employer wanting to allow your employees to pay group health and other insurance premiums with pre-tax salary deductions, the answer is yes, you need a Section 125 plan document.

In most employer-sponsored group benefit plans, employees pay for health insurance and other qualified benefits with tax-free dollars. It’s just taken for granted; that’s the way it’s done.

However, that tax-advantaged treatment is not automatic. The employer must do it through a Premium-Only Plan (POP) or Cafeteria plan, and set up one of those, you need a Section 125 plan document.

Section 125 Plans, also known as a “Premium Conversion Plan”, “Cafeteria Plan” or “Premium Only Plan (POP)”, allow employee contributions to employer-sponsored benefit plans to be made with pre-tax dollars, automatically increasing take-home pay while reducing the employer’s payroll tax liability. POPs are an effective way for a small business to customize employee benefits for maximum tax savings and appeal. These plans are designed to benefit all eligible employees and not just owners or highly compensated employees. These plans are generally not suitable for one-person businesses and may have limited appeal for businesses without salaried employees.

Qualified Premiums Include:

Not all insurance policies may be included within the Section 125 plan. Here are the available types of plans that may benefit from the pre-taxable savings:

  • Health
  • Prescription
  • Dental
  • Vision
  • Employee Group Term Life (up to $50,000)
  • Voluntary Benefits
  • Accident
  • Disability
  • Cancer
  • Supplemental Medical or “Gap” programs

Employees can save roughly 20 – 40% of their insurance premiums by pre-taxing Federal, FICA, and, in most cases, state taxes.

Employers save the matching Social Security and Medicare taxes, and sometimes Federal and State unemployment taxes. Depending on the state, employers may also be eligible for worker’s compensation savings.

Employer Advantages

Employee benefits purchased on a pre-tax basis reduce the employer wage base for purposes of calculating payroll taxes. Employers can realize direct bottom-line savings from the reduced employer FICA taxes, FUTA taxes, and disability and workers’ compensation insurance premiums (varies state by state).

Employee Advantages

When employees purchase benefits on a pre-tax basis, their compensation is reduced for purposes of calculating wages subject to Federal and FICA (Social Security & Medicare) taxes. Based on 2007 tax rates, potential savings can range from 17.65% to 35.65% depending on an employee’s individual tax bracket, and, in most states, employees can also save on their state income tax.

A Premium Only Plan allows employees to pre-tax their contribution toward certain types of insurance including their employer provided health coverage, group benefits such as dental and group term life, and employee voluntary benefits such as accident, supplemental health, disability, and cancer coverage.

Steps to implement a Section 125 Plan

  1. Adopt a written plan document that reflects the plan’s design and
    complies with Section 125;
  2. Update plan enrollment forms to include the rules for Section 125
    plan elections; and
  3. Select a vendor to perform nondiscrimination testing.

Key Legal Requirements

To receive a federal tax advantage,
Section 125 plans must comply with
the following legal rules:

  • Must have a written plan
  • Only common law employees may
    participate on pre-tax basis;
  • Elections are generally irrevocable
    for entire plan year; and
  • Must pass certain nondiscrimination

Types of Section 125 Plans

There are different types of Section 125 plans that employers can choose from when setting up their
cafeteria plans. The four basic forms of Section 125 plans are as follows:

Type of Plan Description
Premium Payment Plan A premium payment plan is the most basic—and most popular—type of Section 125 plan. It is also called a “premium only plan” or “premium conversion plan.” A key feature of this type of plan is that it allows employees to pay their portion of premiums for qualified benefits with pre-tax dollars. Premium payment plans may also offer a cash-out option (additional taxable wages) for employees who decline insurance coverage.
Flexible Spending Arrangements A Section 125 plan may allow employees to purchase benefits under a flexible spending arrangement (a health FSA, DCAP or both) on a pre-tax basis. A health FSA reimburses eligible out-of-pocket medical care expenses. A DCAP reimburses expenses that are for the care of one or more qualifying individuals and that enable the employee (and the employee’s spouse) to be gainfully employed. Additional legal requirements apply to health FSAs and DCAPs. This type of Section 125 plan may also incorporate a premium payment component, or the flexible spending arrangement may be the only benefit offered under the plan.
Full Cafeteria Plan (full flex plan) Under a full cafeteria plan, the employer makes contributions for eligible employees. Employees may spend the employer contribution, which are sometimes called “flex credits,” to purchase any of the benefits offered within the cafeteria plan, such as premium payments for qualified benefits, a health FSA or a DCAP. If the plan includes a cash-out option and the employer’s contribution exceeds the cost of the benefits selected by an employee, then the employee may take the excess amount as additional taxable wages. In addition, the employee may contribute pre-tax dollars to purchase additional benefits beyond what he or she can purchase with the employer’s contributions.
Simple Cafeteria Plan Eligible small employers (100 or fewer employees) may establish “simple cafeteria plans” in order to avoid the nondiscrimination rules for Section 125 plans and certain component benefits offered under the plan. A plan qualifies as a simple cafeteria if it meets certain contribution, eligibility and participation requirements.

Nondiscrimination Tests

Section 125 plans must generally pass certain tests that are designed to ensure that the plan does not discriminate in favor of highly compensated employees. If a cafeteria plan fails to pass nondiscrimination testing, highly compensated employees lose the tax benefits of participating in the plan (that is, they must include the benefits or compensation in their income). However, even if a cafeteria plan is discriminatory, non-highly compensated employees will not lose the tax benefits of participating in the plan

In general, a cafeteria plan must satisfy the following three nondiscrimination tests:

1. Eligibility Test: This test looks at whether a sufficient number of non-highly compensated employees are eligible to participate in the cafeteria plan. If too many non-highly compensated employees are ineligible to participate, the plan will fail this discrimination test.

2. Benefits and Contributions Test: This test is designed to make sure that a plan’s contributions and benefits are available on a nondiscriminatory basis and that highly compensated employees do not select more nontaxable benefits than non-highly compensated employees select.

3. Key Employee Concentration Test: This test looks at whether key employees impermissibly utilize the plan’s benefits more than non-key employees. Under this text, key employees must not receive more than 25 percent of the aggregate nontaxable benefits provided to all employees.

Certain exceptions and safe harbors apply to the cafeteria plan nondiscrimination tests. For example, a Section 125 plan that is a premium-only plan is deemed to satisfy the cafeteria plan nondiscrimination requirements if it passes the eligibility test. In other words, the plan will automatically satisfy the contributions and benefits test and the key employee concentration test if it passes the eligibility test. In addition, simple cafeteria plans are treated as meeting the Section 125 nondiscrimination requirements as long as certain eligibility, participation, and minimum contribution requirements are met.

Reporting & Disclosure

Because a Section 125 plan is a tax savings arrangement, it generally is not subject to the reporting and disclosure requirements that apply to employee benefit plans under federal law. This means, for example, that a Section 125 plan is not required to file an annual Form 5500 with the Department of Labor (DOL) and is not required to have a summary plan description (SPD). However, many of the benefits that can be purchased on a tax-free basis through a Section 125 plan (for example, a health FSA) are subject to the federal reporting and disclosure requirements for employee benefit plans, unless an exception applies.

When to Update your Section 125 Plan

We recommend to update your POP Plan on an annual basis. Here are other times when you would need to renew or update your Section 125 plan documents:

  • If there are changes to the benefits plan
  • Employer changes address or EIN
  • Employer adds or removes a benefit option
  • Employer changes their contribution amount
  • Employer changes eligibility requirements
  • The plan effective date changes
  • New legislation or regulatory changes
  • CARES Act
  • Changes to rules for cafeteria plan
  • Election period extensions

Know the Risks for Non-Compliance

You could be hit with some penalties for not having a Section 125 Plan:

  • The penalty per conviction for willfully violating any requirement of Title I of ERISA could be $100,000 or imprisonment for up to ten years.
  • The plan administrator may be charged up to $110 per day if it does not provide the plan document within 30 days after an individual’s request.

Employees Desire Additional Lines of Coverage

In addition to the direct financial return on investment, companies have seen reductions in employee absenteeism, staff turnover and employee stress. Interested in seeing these results?