Section 125 Plan

What is a Section 125 plan?

A Section 125 cafeteria plan lets your employees pay for health insurance, Health Savings Account (HSA) contributions, Flexible Spending Account (FSA) elections, and other benefits with pretax dollars. Because those dollars come out before taxes, your employees lower their taxable income and reduce what they owe in federal income tax, Social Security, and Medicare on every paycheck.

It's called a cafeteria plan because your employees choose from a menu of flexible benefit options: group health, dental, vision, FSA, HSA, and dependent care during annual open enrollment. Each employee picks what works for them.

Whether you have 2 employees or 20, the structure and tax savings are the same. A Section 125 cafeteria plan can work for any business size.

SurePayroll By Paychex supports pretax benefit deductions as part of standard payroll setup — so your Section 125 elections are calculated consistently each pay run.

What you can offer through Section 125

Section 125 gives you a menu of qualifying benefits to build from. The right mix depends on what you and your team value most.

Group health insurance is where most employers start. When your employees pay their premiums through pretax payroll deductions, you're offering a benefit that helps you compete for top talent and retain the people you have.

FSAs help your employees stretch their healthcare dollars. A healthcare FSA allows employees to contribute up to $3,400 pretax for 2026 to cover eligible medical expenses. A dependent care FSA allows employees to contribute up to $7,500 per household ($3,750 if married filing separately) in pretax funds for eligible dependent care expenses, such as daycare and after-school care. Your employees set their contribution at enrollment; you handle the deductions through payroll.

HSAs allow employees to save for future healthcare costs as well as cover current costs. If you offer a high-deductible health plan, your employees can contribute pretax to an HSA through Section 125. You can also contribute to their accounts.

You can round out the benefits package with dental, vision, and group-term life insurance. Not every benefit qualifies; education assistance and deferred compensation are common examples that don't. Your broker or benefits administrator can confirm what is qualified.

Benefits aren't just a nice-to-have for employees. In a 2025 SurePayroll survey, 28% of job seekers said better benefits was their top reason for looking for a new job

How you save money with Section 125

A cafeteria plan lowers taxes for both you and your employees. When your employees pay for benefits through Section 125, that money comes out of their paycheck before federal income tax, Social Security, and Medicare apply to their wages. Same coverage, lower tax cost.

You save on federal payroll taxes too. You and your employees each pay Federal Insurance Contributions Act (FICA) — covering Social Security (6.2%) and Medicare (1.45%) — on taxable wages. Lower taxable wages mean lower FICA taxes for you and for your employees.

If you have 5 employees each contributing $200 per month toward health insurance pretax, that's $12,000 per year in wages that generally are not subject to FICA taxes. At the employer FICA rate of 7.65%, that could reduce your payroll taxes by about $918 per year.

An employee earning $50,000 annually who contributes $2,400 per year toward health insurance on a pretax basis could save roughly $475 to $700 per year in combined federal income and payroll taxes, depending on their tax bracket, location, and individual tax situation.

Employees make their elections once per year during an open enrollment period you set. Their choices stay in place for the entire plan year. If they experience a qualifying life event such as getting married, having a child, or losing other coverage, they can update their elections mid-year. Otherwise, the pretax deductions are in place for each pay period.

Who sets up your Section 125 plan

An insurance broker or benefits administrator typically helps you set up your Section 125 plan. They prepare the plan document, help ensure it aligns with IRS requirements, and support ongoing compliance tasks like nondiscrimination testing and updates when rules change or you add benefits.  

Section 125 cafeteria plans are generally subject to IRS nondiscrimination rules, which are intended to help ensure the plan does not favor highly compensated employees or key employees.

You choose which benefits to offer, such as health insurance, FSA, HSA, dental, and vision, based on what fits your team and your budget.

Once the written plan is in place, you review the documentation and sign to implement it for your business.

How Section 125 works in your payroll system

You handle the operational side once your Section 125 plan is set and your employees have made their elections. That includes setting up a pretax deduction for each benefit type in your payroll — medical, dental, vision, HSA, and FSA — and assigning each employee to what they elected. Your broker supports IRS compliance.

When you run payroll each period, pretax deductions come out based on each employee's elections. If your employee elected $200 per month for their FSA, you deduct that amount before taxes, lowering their taxable wages for the period.

Your employees see each benefit deduction listed on their pay stubs with a year-to-date total. At year-end, you report Section 125 deductions on each employee’s W-2. Some Section 125 amounts appear on the W-2, depending on the benefit type (for example, HSA contributions in Box 12 and dependent care in Box 10).  

If you use automated payroll software, your payroll system generates those amounts automatically.

Running payroll with Section 125 deductions

With SurePayroll, Section 125 deductions are built into your payroll setup. You set up deductions for medical, dental, vision, and HSA contributions as pretax company ​​deductions. The system calculates the math, deducting amounts automatically each pay period and showing clear breakdowns on employee paystubs.

Get started with SurePayroll.