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Section 125 Plan

What is a Section 125 Plan?

Section 125 plans are often referred to as "cafeteria plans." These plans are referred to this way because participants can pick and choose or "elect" which, if any, benefits they would like to receive on a pre-tax basis.

Participants in a cafeteria plan must be permitted to choose from a minimum of two or more benefits —

  • at least one taxable benefit (such as cash) and,
  • one qualified benefit.

Specifically, a cafeteria plan is defined as a separate written plan maintained by employers for employees that meets the specific requirements and regulations of Section 125 of the Internal Revenue Code. The written Section 125 plan must be intended to be a permanent plan and specifically describe all benefits while establishing rules for eligibility and elections.

Cafeteria Plan Benefits

As an employer, cafeteria plans allow you to give employees access to a flexible benefits program that allows them to make benefit elections that meet their specific needs. The choice is made between taxable and non-taxable qualified benefits. Qualified benefits include:

  • Accident and health plans
  • Dependent care assistance programs
  • Group-term life insurance
  • Short-term or long-term disability coverage
  • Health Savings Accounts (HSA)
  • Elective contributions to qualifying cash or deferred arrangement plans
  • Elective vacation days
  • Cash
  • FSA
  • Adoption assistance

There are also a number of benefits that cannot be included in a Section 125 cafeteria plan. These benefits include:

  • Educational assistance
  • Scholarship/fellowship grants
  • Commuter van rides
  • De minimis fringes
  • No-additional cost services
  • Employee discounts
  • Working condition fringes
  • Deferred compensation arrangement (except as part of a qualifying 401 (k) plan)
  • Qualifying transportation fringe benefits

Cafeteria Plan Rules

A Section 125 plan is the only means by which you can offer employees a choice between taxable and nontaxable benefits without the choice causing the benefits to become taxable. A Section 125 plan typically prohibits the deferral of compensation. However, there are four exceptions to this general rule:

  1. When dealing with cash or deferred arrangements involving a 401(k) plan that allows employees to contribute part of their salary on a pre-tax basis.
  2. Contributions to Health Savings Accounts (HSAs) that allow deposits to be carried forward into the following year.
  3. Flexible Spending Accounts (FSAs) that get a grace period of 2 1/2 months following the end of a plan year for participants to still incur eligible expenses.
  4. Your matching contributions as an employer are also allowed to be deferred as part of the Section 125 plan.

 

Flexible Benefits

Payroll is likely to be involved to some extent with regard to the funding of Section 125 plans. These plans can be funded in a number of ways. So-called flex dollars are funded by your contributions as an employer. Each employee is provided a certain number of flex dollars that he or she can use to buy selections from the plan or choose to receive as cash. Employees can use part of their salary to purchase benefit selections through either pre-tax or after-tax deductions, which typically results in a larger amount of take-home pay. Some regulations that are still in the proposal stage allow Section 125 plans to offer after-tax contributions for qualified benefits.

When running payroll, a qualified benefit's value is not included in an employee's gross income. However, when cash is the chosen benefit, it is to be included as part of the employee's income.

Ultimately, cafeteria plans are beneficial to both employees and employers. The amount of wage reduction resulting from cafeteria plan elections is not subject to social security and Medicare taxes. As a result, it also reduces the employer's share of these taxes. Also, the wage reduction is not subject to Federal Unemployment Tax Act (FUTA) taxes. On the other hand, prohibited benefits that are part of a cafeteria plan are taxable.