Using Section 125 Plans to Save On Health Care Premiums

Provide Benefits with Lower Taxes and Lower Premiums

Light shining on skeleton key and handwritten word 'Benefits'.
Image courtesy of [blackred] / Getty Images.

Small business owners who wish to provide fringe benefits to their employees should consider establishing a Section 125 Plan. Also known as a cafeteria plan, a Section 125 Plan allows employees to use pre-tax income to purchase certain types of benefits. It can be a valuable money-saving tool for both employers and their workers.

What Is It?

A section 125 Plan is a benefit scheme that is permitted under U.S. tax laws.

It enables employers to offer health insurance and other benefits to their workers at a reduced cost.

The name "Section 125 Plan" derives from Title 26, Section 125 of the United States tax code. This law outlines the rules employers must follow when establishing a cafeteria plan. It defines the term cafeteria plan, and describes the types of benefits such a plan may include. The law prohibits plans that discriminate against lower-paid workers by favoring those that are highly compensated. If an employer's plan is found to be discriminatory, the benefits it provides to highly-paid workers will be taxed.

How the Plans Work

Under a 125 Plan, employees pay for benefits via a payroll deduction. The money deducted from workers' pay is shielded from taxes, so employees retain a greater portion of their earnings. Employers save money as well, since the amount deducted from workers' pay is exempt from Social Security and Medicare taxes.

For a plan to qualify as a cafeteria plan, all participants must be employees. The plan must allow employees to choose among two or more benefits, one of which must be taxable (such as cash). The other benefit must be a qualified benefit such as one the following:

  • Health Insurance Premiums for employer-sponsored health insurance are deducted from employees' pay before taxes are applied.
  • Dental, Accident or Group Life Insurance Premiums may also be deducted for dental, accident, or group life insurance.
  • Health Flexible Spending Account Under a healthcare FSA, an employee elects to have a specified amount of money deducted from his or her pretax earnings each pay period. The funds are deposited into an account. The worker can withdraw the money to obtain reimbursement for qualified medical expenses that aren't covered by insurance.
  • Dependent Care Flexible Spending Account As its name suggests, a dependent care FSA is money that can be used to care for a dependent. When a DCFSA is available, a worker may opt a deduction of up $5,000 from his or her pretax income. The money may be used to care for a dependent child under 13, or a dependent spouse or parent that resides with the worker.

Advantages

A Section 125 Plan provides flexibility. Employers decide the types of benefits they want to include, such as medical, dental, and vision care. They can also provide spending accounts that workers can use to pay medical and child care expenses. Employees choose the benefits they want, and then pay for the benefits through payroll deductions. The funds deducted from workers' pay are excluded from their gross income.

These funds are exempt from state and federal taxes.

Because employees' contributions are tax-free, workers may achieve a significant savings on the cost of their benefits.  Moreover, the premium contributions paid by employees help lower the cost of the benefits for employers. The result is a win-win. Both employees and employers save money on benefits. 125 Plans help small employers remain competitive in the marketplace by enabling them to offer employee benefits.

Section 125 Plans offer additional advantages to employers. These include:

  • FICA Contribution Savings Because employees' contributions are not subject to social security and Medicare (FICA) taxes, an employer need not pay FICA taxes on those amounts. Thus, a business can save 7.65 cents for every dollar contributed.
  • Workers' Compensation Premium Savings  Workers compensation premiums are based on payroll. In some states, the employer's payroll is reduced by contributions (reductions in salary) made by employees and by contributions made by the employer to fund employee benefits. The result is lower workers' compensation premiums.

    Administration

    Employers incur costs to establish, administer and comply with a 125 Plan. You can administer your plan yourself or hire someone else to administer it for you. Administrative services are available from health insurance companies and independent administrators. The costs to administer a 125 Plan are quickly offset by the savings in FICA and workers' compensation premiums. Thus, an employer can save money overall by implementing a 125 Plan. Check with your business health insurer or insurance agent to see if a 125 Plan makes sense for your company.

    Simple Cafeteria Plan

    Under Section 125 of the U.S. tax code, companies are penalized for benefit plans that discriminate in favor of highly-paid workers or key employees. Small firms employ relatively few workers, so they are more likely to be affected by the penalty than large companies. Thus, many small companies have avoided cafeteria plans.

    The IRS introduced a new plan for small employers in 2010. Called the simple cafeteria plan, this new plan has more lenient non-discrimination requirements than the traditional 125 plan. The simple cafeteria plan is available to businesses that employ 100 or fewer workers.

    Edited by Marianne Bonner