A Section 125 plan, often called a cafeteria plan, is an IRS-approved benefits structure that allows employees to pay for certain benefits using pre-tax dollars. This reduces their taxable income, increases take-home pay, and helps employers lower payroll tax expenses.
Named after Section 125 of the Internal Revenue Code, this plan creates a win-win scenario for both employers and employees—boosting benefits without increasing costs.
Receive their full salary as taxable income OR
Redirect a portion of their salary to pay for qualified benefits before taxes are applied
By selecting pre-tax benefits, employees pay less in federal income tax, Social Security (FICA), and Medicare taxes.
Employers benefit as well—since their payroll tax obligations are based on taxable wages, reducing employee taxable income also reduces the employer's payroll tax liability.
Payroll Tax Savings
Employers save around $600–$1,200 per year per participating employee on payroll taxes.
Enhanced Benefits Without Added Costs
Section 125 plans let employers offer more competitive benefits without raising salaries or insurance premiums.
Improved Retention & Recruitment
Benefits are a key driver in employee satisfaction. Pre-tax benefit structures can attract and retain talent in a cost-effective way.
Many modern Section 125 solutions are fully managed by third-party administrators, requiring minimal lift from internal HR or payroll teams.
Employees enrolled in a Section 125 plan enjoy
Higher Take-Home Pay
Lower taxable income = more money in their paycheck
Access to Benefits
Health, dental, vision, life insurance, telehealth, wellness services, and more
Family & Dependent Coverage
Many plans cover spouses and children without additional taxable income
Let’s say Sarah earns $50,000 annually. She elects $4,000 in pre-tax benefits through her Section 125 plan. She’s now taxed on $46,000 instead of $50,000—resulting in hundreds in annual tax savings.
Her employer also avoids FICA taxes on the $4,000 difference.
Eligible benefits under Section 125 include:
Health, dental, and vision insurance premiums
Group term life insurance (up to $50,000)
Flexible Spending Accounts (FSAs)
Dependent care assistance
Certain wellness programs (like PCMP)
Not allowed: tuition reimbursement, gym memberships, transportation, or other fringe benefits unless covered under another IRS code section.
To stay compliant, employers must have a formal Section 125 Plan Document that outlines:
Plan year
Benefits offered
Eligibility rules
Election/change procedures
Employees must also receive a Summary Plan Description (SPD) that explains the plan in simple terms.
Failure to maintain these documents can result in IRS disqualification and retroactive tax penalties.
Any U.S. employer with at least one eligible W-2 employee can establish a Section 125 plan. It’s commonly used by:
(5–50 employees)
(50–500 employees)
National and enterprise employers
Nonprofits and school districts
Plans are typically administered through payroll and can integrate with existing benefits platforms.
Pros
Cons
Low cost to set up
Requires documentation and IRS testing
Saves money for both employer and employee
Not all benefits qualify
Boosts employee retention and morale
Plan changes limited to open enrollment or life events
Works with existing benefits
Needs oversight or third-party administration
Section 125 was added to the U.S. Internal Revenue Code in 1978 as part of legislation designed to give employees more flexibility and tax advantages when selecting their benefits.
Before Section 125, any employer-provided benefits that allowed employee choice could result in taxable income. The new law clarified that if structured properly, certain employee choices—like opting into health insurance or pre-tax deductions—would not be treated as taxable income.
Legal Significance:
IRS Code Section 125 outlines the criteria and rules for cafeteria plans.
The Department of the Treasury and IRS issue further regulations and guidance over time.
Employers must meet strict documentation and nondiscrimination requirements to ensure their plan remains compliant and tax-favored.
Section 125 plans are now widely implemented across private companies, nonprofits, and government entities as a cornerstone of modern employee benefits.
No. An FSA (Flexible Spending Account) is one type of benefit that can be offered under a Section 125 plan.
Not necessarily, but you do need a compliant plan document. Many employers use a third-party administrator.
The plan can be disqualified, and pre-tax benefits may become taxable.
Every plan must have a written plan document, a Summary Plan Description (SPD), and pass annual nondiscrimination testing to remain IRS-compliant.
Yes. If a plan is found to favor highly compensated employees, their pre-tax benefits may become taxable.
Generally, C-corp owners can participate, but S-corp owners, sole proprietors, and partners are excluded.
In most states, Section 125 elections reduce state income tax as well. However, some states (like NJ) do not follow federal rules.
Yes. In fact, most plans are layered on top of existing medical benefits to reduce premium costs and enhance employee offerings.
A Section 125 plan is one of the simplest, most effective ways to reduce payroll taxes and increase the value of your employee benefits—without raising your budget.
Understanding how it works is the first step. From there, you can choose the right plan type, ensure compliance, and decide if a fully managed solution is right for your team.
Whether you're an HR manager, business owner, or employee, navigating Section 125 can be confusing. We're here to help.
Submit your question below and our team will get back to you within 1-3 business day.
