Section 125 Cafeteria Plans: Tax-Free Health Benefits
A Section 125 cafeteria plan (named after the IRS tax code section) allows employers and employees to pay for health insurance premiums with pre-tax dollars. Without a Section 125 plan, employee contributions to health insurance premiums are paid with after-tax dollars. With a properly structured Section 125 plan, both the employer and employee save payroll taxes (FICA) on those premiums.
Tax Savings Calculation
For an employee contributing $300/month to their health insurance premium: without Section 125, they pay $300 from after-tax income. With Section 125, the $300 is deducted pre-tax, reducing taxable income. At a combined federal/state/FICA marginal rate of 35%, that employee saves $105/month ($1,260/year) in taxes. For the employer: the same $300 reduction in employee taxable wages reduces employer FICA by $22.95/month ($275/year per employee). On a 20-person group, that's $5,500/year in employer FICA savings.
Plan Document Requirement
To qualify for Section 125 pre-tax treatment, employers must have a written plan document that describes the plan, eligible employees, benefits offered, and election procedures. The plan document is an IRS requirement — verbal agreements or side arrangements don't qualify. Plan documents can be prepared by your insurance broker, a benefits attorney, or a third-party administrator. Plan documents must be updated when benefits change, and annual nondiscrimination testing is required.
FSA and Dependent Care Accounts
Section 125 plans can also include flexible spending accounts (FSAs) for medical expenses and dependent care FSAs (DCFSAs). Health FSAs allow employees to set aside up to $3,200/year (2025 limit) pre-tax for qualifying medical expenses. DCFSAs allow up to $5,000/year pre-tax for dependent care costs. Both types of FSAs are funded through payroll deductions and provide immediate tax savings.