What is a Section 125 Plan? Benefits and Options to Consider
A robust employee benefits plan is a great way to help you attract and retain talent. When selecting benefit offerings, it’s important to provide options that help plan participants save money while strengthening their loyalty to your business. To help you avoid confusion, here are some quick explanations of commonly misunderstood tax-saving benefit options you can offer your employees.
What is a section 125 plan?
In a section 125 plan or cafeteria plan, employees can pay qualified medical, dental, or dependent-care expenses on a pretax basis, which has the effect of reducing their taxable income as well as their employer's Social Security (FICA) liability, federal income and unemployment taxes, and state unemployment taxes where applicable. With health care costs continually on the rise, a section 125 plan can not only help augment your employee benefits package, but it also offers certain employer and employee tax advantages.
What is a section 125 plan designed to do?
According to the IRS, a section 125 plan provides employees with an opportunity to receive certain benefits on a pre-tax basis. This money is taken out of the individual's gross pay and can be used for items such as group health insurance premiums, qualified out-of-pocket medical expenses, and daycare for eligible dependents. For example, if an employee is taxed on 30 percent of their income, and if they direct $100 of their pre-tax pay to a section 125 account, they would be able to spend the full amount on qualified medical expenses, rather than only $70 received on an after-tax basis.
Under a section 125 benefits plan, employers also see a reduction in the amount of income used to determine payroll taxes, and experience a reduction in the associated tax liabilities for Medicare, Social Security, and unemployment. There may also be additional savings on withholding taxes in some states.
How do you start a section 125 plan?
Premium Only Plans (POP) and flexible spending accounts (FSA) for medical and dependent-care benefits are often referred to as section 125 plans because they are each described in Section 125 of the Internal Revenue Code (dependent care under Section 129). If you're considering adding one of more of these benefits, it's a good idea to review the IRS Employer's Guide to Fringe Benefits section on cafeteria plans to help you understand the types of benefits that fall under this category.
Often, a third-party administrator can be the easiest route to help you set up a new employee benefits plan and manage day-to-day administration. Integrated HR technology can also help link benefits and payroll processing to ensure the proper employer and employee contributions are made and taxes are correctly calculated. According to the 2018 Paychex Pulse of HR Survey, respondents said that using HR technology helped them improve overall employee experience, and more than half of respondents said they’re likely to use such applications for benefits administration.
Section 125 plan types
As with food service, a cafeteria plan allows employees to pick benefits from a menu of offerings. Any costs beyond the maximum your company will pay then become the responsibility of the employees, paid for via payroll deductions throughout the year. Together with POPs and FSAs, as well as non-section 125 plans such as an Adoption Assistance Plan, cafeteria plans allow pre-tax deductions, which may help employees pay less in taxes.
A Premium Only Plan (POP) is a great way to save on insurance premiums with pre-tax dollars contributing to the overall cost. In combination with group health insurance, a POP reduces taxable income and results in a reduction in the amount used to determine your company's FICA (Federal Insurance Contributions Act) and FUTA (Federal Unemployment Tax Act) payroll taxes, and any applicable state taxes.
When setting up this type of plan, employee participants may have their health care premium payments taken out from their paychecks before taxes are deducted, which in effect reduces the amount of income used for tax calculations. If you're thinking about adding this benefit, it's important to note that a POP may only be offered by an employer with a group medical plan.
Offered solely in conjunction with a group medical plan, FSA benefits help employees budget for predictable out-of-pocket medical and dependent care expenses, such as daycare, routine prescriptions, or elder care. Consider how much an employee's household might spend in a year on expenses such as maintenance medications (medication taken daily or weekly), yearly eye care expenses, routine or special-need dental work, and weekly or summer daycare costs. Flexible spending account rules allow pre-tax deductions to be used to fund these expenses and can lead to significant amounts saved each quarter and each year.
Pros and cons of section 125 plans
Only you can decide if and when it makes sense for your company to offer a section 125 plan to employees. In addition to medical, dental, and vision, section 125 plans are a valuable, cost-saving benefit. Employees enjoy the flexibility of using these accounts so they can better control their tax liabilities. Additionally, employers can defray some of the costs associated with managing other plans with section 125 tax advantages.
Consider some of the benefits of section 125 plans:
- Employee tax savings. Saves employees on federal, and most state and local withholding taxes while helping them pay for eligible out-of-pocket expenses.
- Lower taxable income. Since funds are placed into this account pre-tax, it reduces the amount of taxable income present on a W-2 later in the year.
- Reduction of employer payroll and tax liabilities. For a business owner, a section 125 plan helps to reduce payroll and tax liabilities, including FICA and FUTA.
These benefits can help to offset the initial plan setup fee and even help the company to save substantially in the long term.
While these plans have many benefits, it is important to examine the potential drawbacks of a section 125 plan before electing to use them:
- Limited time frames: Participants who put funds into a section 125 plan must use those funds during the plan year, otherwise those funds will be lost. Proper planning is essential from an employee standpoint.
- Employees fund expenses upfront: Employees are reimbursed for expenses as part of a health flexible spending account. This means expenses must be paid out of pocket first and are reimbursed after a claim is made.
- Initial setup fees: For the employer, an initial setup fee is present. This fee is minimized as a result of the significant savings present over the long term.
Overall, these drawbacks may not be as problematic as overpaying for other services. You may want to consider speaking to your tax accountant about how a section 125 plan could impact your business directly.
Health savings accounts (HSAs)
An employee's eligibility for an HSA depends on the use of a high deductible health plan. Participants have a chosen amount, within limits outlined by the IRS, deducted from their paychecks on a pre-tax basis to be spent on certain medical needs. The additional benefit of an HSA is that any funds that remain unused at the end of the year roll over into the next, whereas FSA funds are lost at the close of the plan year.
If you decide to offer a section 125 plan or HSA to your employees, you'll need to include the plan(s) as part of your annual enrollment period, so that eligible employees may sign up, maximize the usage of new benefits, and potentially save money on taxes.
Do the requirements for administering section 125 plans seem onerous? An experienced third-party administrator can offer support by helping you handle the daily tasks associated with these plans and other benefit offerings.