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The Section 125 Cafeteria Plan: A Guide for HR Professionals
A Section 125 cafeteria plan is a written employer plan, allowed under Section 125 of the Internal Revenue Code, that lets employees pay for certain benefits such as health insurance premiums, flexible spending accounts and dependent care with pretax dollars, which lowers payroll taxes for both the employee and the employer. This guide covers how a Section 125 plan works, which benefits qualify, the plan types you can choose from, who can't participate, and how to set one up so the tax savings hold up.
Key Takeaways from this Article
- A Section 125 plan lets employees pay for qualified benefits, like their share of health insurance premiums, before federal income tax, Social Security and Medicare are taken out.
- The employer saves too, because it pays its 7.65% share of Social Security and Medicare on a smaller amount of wages.
- The plan has to be in writing before anyone takes a pretax deduction, and many small businesses are running pretax deductions without that document.
- Sole proprietors, partners and S corporation owners with more than 2% of the company can't participate.
- Elections are locked in for the plan year unless the employee has a qualifying event, such as marriage, a new baby or losing other coverage.
A strong benefits package is one of the ways a small business can attract and keep good employees. A Section 125 plan doesn't add a new benefit on its own. What it does is make the benefits you already offer cost less for everyone involved, which is why it's one of the first things we look for when a new client comes on board.
What Is a Section 125 Plan and How Does It Work?
A Section 125 plan, also called a cafeteria plan, is a written plan that gives employees a choice between taking cash wages and putting part of that pay toward qualified benefits. Money directed to those benefits comes out of the paycheck before taxes, so it isn't treated as taxable income for federal income tax, Social Security or Medicare.
The name comes from the idea of a cafeteria line. Employees pick from a menu of benefits, and anything they choose is paid for through a payroll deduction instead of out of their take home pay.
Here's how it plays out in practice:
- Before the plan year starts, or when they're hired, the employee decides which benefits to enroll in and how much to set aside.
- Each payday, payroll subtracts those amounts from gross pay before calculating withholding.
- Federal income tax, Social Security and Medicare are figured on the smaller amount that's left.
- The employer's share of Social Security and Medicare, and its federal unemployment tax (FUTA), are figured on that smaller amount too.
According to IRS Publication 15-B, a qualified benefit chosen through the plan stays tax free even though the employee could have taken the cash instead. Without a valid plan, that choice alone can make the benefit taxable.
What Deductions and Expenses Can Be Written Off with a Section 125 Plan?
A Section 125 plan can shelter the employee's share of health, dental and vision premiums, out of pocket medical costs through a flexible spending account, dependent care costs, and HSA contributions. The savings show up in two places: the employee's paycheck and the employer's payroll tax bill.
Picture a dental office in Augusta with 15 employees. One hygienist earns $4,000 a month and pays $200 a month toward her health insurance. Here's what a year looks like with and without a Section 125 plan, assuming she's in the 12% federal income tax bracket.
| Annual figures for one employee | Premiums taken after tax | Premiums taken through a Section 125 plan |
|---|---|---|
| Wages subject to Social Security and Medicare | $48,000 | $45,600 |
| Employee Social Security and Medicare (7.65%) | $3,672.00 | $3,488.40 |
| Employer Social Security and Medicare (7.65%) | $3,672.00 | $3,488.40 |
| Federal income tax on the $2,400 in premiums (12% bracket) | $288.00 | $0 |
The hygienist keeps about $471 more in her pocket for the year, before counting state income tax. The office saves $183.60 in its share of Social Security and Medicare for her alone. If all 15 employees pay the same premium through the plan, that's $2,754 a year the business no longer sends to the IRS, just for paying premiums the right way.
For businesses here, Maine's income tax starts from federal adjusted gross income, so pretax premiums and FSA contributions generally lower Maine taxable wages as well. HSAs are the one to double check. Maine has treated HSA contributions differently from the federal rules in the past, so ask us how yours should be reported before you assume the federal treatment carries over.
What Are the Different Types of Section 125 Plans?
There are five common types of Section 125 plans, and many small businesses start with the simplest one and add to it later. You can also combine more than one under the same plan document.
Premium Only Plan (POP)
A premium only plan lets employees pay their share of group health, dental or vision premiums before taxes. It's the most common starting point for a small business that already offers a group health plan, and it's the plan behind the example above.
Health Flexible Spending Account (FSA)
A health FSA lets employees set aside pretax money for out of pocket medical costs like deductibles, copays, prescriptions and glasses. For plan years starting in 2026, the IRS caps employee contributions at $3,400. Unused money is generally lost at the end of the year, although a plan can offer a short grace period or a limited carryover instead.
Dependent Care FSA
A dependent care FSA, also called a dependent care assistance program, covers costs like daycare, after school programs and summer day camp so a parent can work. Starting in 2026, the yearly exclusion is $7,500 per household ($3,750 for married employees filing separately), up from $5,000.
Simple Cafeteria Plan
A simple cafeteria plan is built for small employers. If you averaged 100 or fewer employees in either of the two prior years, you can use one and skip the annual nondiscrimination testing, as long as you make the required employer contribution for every eligible employee. You can keep the plan until the year after you average 200 or more employees.
Full Flex Plan
A full flex plan gives each employee an employer funded allowance to spend across a menu of benefits. If the benefits they pick cost more than the allowance, they cover the difference through pretax deductions. This setup fits larger employers that want to offer several plan options without paying for benefits an employee won't use.
What Benefits Are Included in Section 125?
The IRS calls the benefits a Section 125 plan can offer "qualified benefits." According to IRS Publication 15-B, they include:
- Accident and health coverage, including medical, dental and vision premiums and health FSAs
- Dependent care assistance
- Adoption assistance
- Group term life insurance coverage
- Health savings account contributions (see our guide to yearly HSA contribution limits)
- A qualified 401(k) plan, which is the one exception to the rule that a cafeteria plan can't defer pay
What Benefits Are Not Included in Section 125?
You can still offer the benefits below, but they can't be paid for with pretax dollars through a Section 125 plan:
- Long term care insurance
- Educational and tuition assistance
- Commuter and parking benefits
- Gym and athletic facility memberships
- Employee discounts
- Employer provided cell phones
- Meals and lodging
- Small, occasional perks known as de minimis benefits
- Archer MSAs
Some of these have their own tax rules. Commuter benefits and education assistance, for example, can get favorable treatment under separate sections of the tax code with their own plan documents. And many voluntary products, like accident or hospital indemnity coverage sold for individual use, come out after taxes. Our article on pretax and post tax deductions walks through how each kind shows up on a paycheck.
Who Should Consider a Section 125 Plan?
Any employer that offers group health insurance and asks employees to pay part of the premium should have a Section 125 plan. Sole proprietorships, partnerships, LLCs, C corporations, S corporations and nonprofits can all sponsor one. Size doesn't matter. A five person landscaping company in York County saves on the same tax as a 200 person hotel group, just with smaller numbers.
It's less useful for a business that pays 100% of every employee's premium and offers no FSA, since there's no employee contribution to move before taxes.
The owners are the catch. The plan is for employees, so sole proprietors, partners and anyone owning more than 2% of an S corporation can't take pretax deductions through it, even if the rest of the team does. S corp owners follow a separate set of rules, which we cover in our guide to S corporation shareholder health insurance.
How Can Employers Set Up a Section 125 Cafeteria Plan?
Setting up a Section 125 plan starts with a written plan document, adopted before any pretax deductions begin. That document lists the benefits offered, who's eligible, how and when employees make elections, and the plan year. Without it, the IRS can treat every one of those deductions as taxable wages.
From there, the steps look like this:
- Decide which benefits to include. Most small businesses start with a premium only plan and add an FSA later.
- Adopt the plan document and keep a signed copy on file.
- Give employees a summary of the plan and an enrollment window.
- Set up each deduction in payroll as pretax, so it's excluded from the right tax calculations.
- Run nondiscrimination testing each year, unless you're using a simple cafeteria plan, to make sure the plan doesn't favor owners and highly paid employees.
- Update the document whenever your benefits change or the law requires it.
Here's what we see most often. A good portion of the businesses that come to us are already taking health premiums out pretax, and nobody ever told them they needed a plan document behind those deductions. When we spot it, we tell them and help them get one in place. Once the document is on file with us, we set an alert so we can reach out when it's time for an updated plan, instead of finding out years later that it lapsed.
Paper Trails clients can get a Section 125 plan document through us, and we set up the pretax deductions in isolved so they calculate correctly every payroll. If you offer an FSA or HSA, isolved Benefits Services can handle the administration. You can see how it all fits together on our benefits administration page. If you don't have a group health plan yet, ask us. We can introduce you to a benefits broker who works with businesses your size.
What Are Section 125 Cafeteria Plan Qualifying Events?
Section 125 elections are locked in for the full plan year. An employee can only change them midyear after a qualifying event that's consistent with the change they're asking for. Common qualifying events include:
- Marriage, divorce, legal separation or the death of a spouse
- The birth or adoption of a child
- A dependent aging out of coverage or otherwise losing eligibility
- A change in employment status for the employee, spouse or a dependent, such as moving from part time to full time
- Losing other health coverage, such as through a spouse's job
- Becoming eligible for Medicare or Medicaid
- A significant change in the cost or coverage of the plan
Consistency matters here. If an employee gets married in June, adding the new spouse to the health plan makes sense. Dropping their own coverage while gaining a spouse who has no other plan doesn't, and the plan shouldn't allow it. Most plans also ask for proof, like a marriage certificate or a letter showing the loss of other coverage.
FAQs: Section 125 Cafeteria Plans
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Section 125 amounts don't have a required box of their own on Form W-2. Pretax premiums and FSA contributions are simply left out of the wages in Box 1, Box 3 and Box 5, which is why those numbers can be lower than your gross pay. Some employers add an informational line in the Other box, labeled something like Sec 125 or Cafe 125, which starting with 2026 forms is Box 14a. HSA contributions made through the plan are reported in Box 12 with code W, and dependent care benefits appear in Box 10.
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A premium only plan is one type of cafeteria plan. Any plan that meets Section 125 and lets employees choose between cash and at least one qualified benefit counts as a cafeteria plan. A POP limits that choice to paying insurance premiums pretax. A broader cafeteria plan can add health and dependent care FSAs, HSA contributions or an employer funded allowance.
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A line marked Section 125, Sec 125 or Cafe 125 on a paystub shows money taken out for benefits before taxes, usually health insurance premiums or FSA contributions. Because it comes out first, federal income tax, Social Security and Medicare are calculated on a smaller amount, which means more take home pay than the same deduction taken after tax.
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Only employees can participate. Sole proprietors, partners in a partnership and shareholders who own more than 2% of an S corporation are not treated as employees for Section 125, so they can't make pretax elections through the plan. Their family members who work in the business may also be affected by the S corporation ownership rules, so it's worth confirming with your payroll provider or accountant.
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The most common mistake we see is taking pretax deductions with no written plan document at all, which can make every one of those deductions taxable if the IRS takes a look. Others include letting an S corporation owner take premiums pretax, allowing midyear election changes without a qualifying event, skipping nondiscrimination testing on a plan that requires it, and letting a plan document go out of date after benefits change.
Wrapping Up
If you take any part of your employees' health premiums out of their paychecks, look at how those deductions are set up before the end of the year. Check two things: whether they're coded pretax, and whether there's a signed Section 125 plan document on file to back that up. If either answer is "I'm not sure," that's a quick conversation with your payroll provider, and it's a lot easier to fix now than after a W-2 goes out wrong.
Not sure where your plan stands? Reach out to your payroll processor or our local Maine team, and we'll take a look.
Updated: October 2026
Written by: Jon Portanova
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