Article

Managed Accounting, Tax Accounting

Everything You Need to Know About Section 125 Plans

Posted on April 30, 2024

By Michele Roletter

May 17, 2024

As an employer in an increasingly competitive environment, offering exclusive benefits is crucial to prioritize retention and attract qualified talent. One of the avenues employers are turning toward to achieve these strategic goals is Section 125 Plans, also known as Cafeteria Plans.

A Section 125 Plan is an employer-sponsored plan that gives employees access to tax-advantaged health and childcare benefits. Both you and your employees can enjoy FICA tax savings from contributions, making it a great strategy to reduce your taxable income and improve the attractiveness of employment at your business.

In this article, we’ll cover everything you need to know about Section 125 Plans, including the specific tax advantages, eligibility, types of plans, and how you can implement this benefit in your business. If you have any questions about the application of Section 125 Plans in your organization, contact a KDG tax accounting team member right away.

An infographic detailing section 125 plans with options like full-flex and premium-only plans, plus simple and flexible spending accounts, including list of features and associated costs.

Understanding Section 125 Plans

Section 125 Plans can take on many different forms, giving employers the opportunity to customize the benefits offered to employees. The four main types of Section 125 Plans include:

  • Full-Flex Plans – In this type of plan, the employe provides a fixed-dollar amount to each employee. The employee can then choose from a variety of benefits, like childcare and adoption assistance. Any contributions employees make outside of what the employer offers are made with pre-tax dollars.
  • Premium-Only Plans – This type of plan allows employees to choose between having their full salary or having pre-tax deductions taken to cover employer-sponsored insurance plans.
  • Simple Section 125 – This plan is only an option for employers with less than 100 employees, giving employers the ability to contribute to each employee’s benefit package in exchange for the removal of nondiscrimination testing requirements.
  • Flexible Spending Accounts – This plan allows employees to set aside pre-tax funds for qualified health and dependent care expenses.

Section 125 Plans are governed by IRC Section 125, which outlines that permissible benefits include accident and health benefits, adoption assistance, dependent care assistance, group term life insurance coverage, and health savings accounts. These benefits are known as fringe benefits and are outlined in IRS Publication 15-B.

Moreover, the IRS does outline a handful of expenses that are not eligible in a Section 125 Plan. These include athletic facilities, educational assistance, employee discounts, meals, lodging, retirement planning, transportation, and tuition reduction. However, other provisions allow you to offer these types of benefits, just not under a Section 125 Plan.

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Benefits of Section 125 Plans

One of the main advantages of offering Section 125 Plans is the tax benefits for both employers and employees. Section 125 plans give employees pre-tax benefits. This means that the contribution is taken out of the employee’s gross pay before FICA taxes are calculated. The funds can then be withdrawn tax-free when used toward qualifying expenses.

Employers also derive benefits from offering Section 125 Plans. Just like employees can reduce their FICA taxes, employers can as well. The employer’s share of FICA taxes is imposed on the employee’s taxable wages, which removes the pre-tax deduction. Employers can also save on other payroll taxes, like FUTA and SUTA.

Additionally, employers can generate a competitive advantage by offering Section 125 Plans. When prospective employees are choosing between employers, they will evaluate their benefits packages. With a Section 125 Plan in place, you might be able to outperform competitors and attract qualified talent. Not to mention that having a comprehensive benefits package is a motivating factor contributing to retention efforts.

Employee Pre-Tax Contribution Example

Let’s say that your employee earns $1,000 and decides to contribute $100 to a Section 125 plan. Without the $100 contribution, your employee’s tax base for FICA taxes will be $1,000. With Social Security being assessed at a rate of 6.2% and Medicare at a rate of 1.45%, the total tax due is $76.50, creating a net take-home pay of $923.50.

Now, let’s assume that the employee makes a qualified $100 contribution to a Section 125 Plan. The tax base is reduced to $900. Taking the same FICA tax rate of 7.65%, the employee will be assessed $68.85 in taxes, resulting in a net take-home pay of $831.15. The employee is able to save $7.65 in payroll taxes with a pre-tax contribution to a Section 125 Plan. When the employee goes to use the funds, they will have the full $100 to use toward qualifying expenses.

Employer Section 125 Plan Example

Using the above example, employers will also be able to save $7.65 in FICA taxes. However, the tax savings of employers extend beyond FICA, applying to FUTA and SUTA. Let’s say that your SUTA rate is 1%. FUTA is 6% of the first $7,000 of employee wages. With no employee contributions, your business will pay $10 in SUTA and $60 in FUTA taxes.

When the employee makes a $100 pre-tax contribution, your tax base for FUTA and SUTA is dropped to $900. This results in $9 of SUTA taxes and $54 of FUTA taxes, saving your business another $7. Now, multiply these tax savings across numerous employees, and you have the ability to save a significant amount in payroll taxes.

Eligibility and Participation

The IRS does outline specific criteria that employers must meet to participate in a Section 125 Plan. C Corporations, S Corporations, Limited Liability Companies, Partnerships, Sole Proprietorship, and Government entities can all participate in the plan. When forming a Section 125 Plan, extensive documentation is required, which we will discuss in detail later on.

However, there are restrictions on the type of employees that can contribute. For one, contractors are not eligible to participate in the plan. Only employees are eligible. In addition, partners in a Partnership and members in a Limited Liability Company cannot participate. Similarly, shareholders with more than 2% of ownership in an S Corporation are excluded. These plans are designed for employees, not business owners.

To participate in a Section 125 Plan, employees need to be enrolled. Most companies have a specified enrollment period, usually at the end of the year. Mid-year changes are generally not allowed under IRS regulations unless it’s for a name change, change in marital status, or change in eligibility. For a complete list of allowable mid-year changes, review the Code of Federal Regulations Section 1.125-4.

During the annual enrollment period, your employees will outline the benefits they are enrolling in and key identifying information, like their Social Security Number, legal name, and address. This document should be kept in your employee’s file.

Limitations and Considerations

Many components of Section 125 Plans have limitations. Here are some of the notable limitations:

  • Flexible Spending Account – For the 2024 tax year, employees can contribute up to $3,200 to this type of Section 125 Plan. An employee’s spouse can also contribute up to $3,200 to the plan. The maximum carryover amount to 2025 is $640.
  • Health Savings Account – For the 2024 tax year, employees can contribute $4,150 to an individual plan or $8,300 to a family plan. Employees over 55 can contribute an additional $1,000. HSA contributions can be rolled over.
  • Dependent Care FSA – The maximum contribution to a Dependent Care FSA is $5,000 per household or $2,500 per individual for the 2024 tax year. This type of FSA cannot be rolled over.

Section 125 Plans do have changing provisions each year, specifically in the contribution limits. Generally, the IRS will adjust the contribution limits each year due to inflation and other economic circumstances.

It’s important that you make employees aware of the contribution limits and rollover options. You don’t want your employees to lose their pre-tax benefits because they were unaware of the use-it or lose-it provisions.

Planning and Implementation for Employers

Implementing a Section 125 Plan requires proper planning. For one, you need to consider which benefit components to offer to employees. To gauge what types of benefits employees are looking for, consider putting together an anonymous survey or researching what competitors in your industry offer. Once you’ve solidified your selection, you will need to go through the following steps:

  • Draft Plan Document – First, you will need to draft a document of the benefits offered, contribution limits, and the participation rules outlined by the IRS. Provide each employee with a copy of this document.
  • Choose a Plan Administrator – Next, you will need to select a plan administrator to manage your Section 125 Plan. This can be someone in-house or an external third party. Most companies choose to use an external party for independence purposes.
  • Communicate Plans to Employees – One of the most important steps in establishing your Section 125 Plan is communicating the benefits to employees. Hold a training session, schedule a one-on-one meeting, or send comprehensive documentation about the benefits to each employee. Without the proper education and information, you might see little participation from employees.
  • Monitor and Adjust the Plan – Once your Section 125 Plan is functioning, you will need to monitor and adjust benefits. This includes ensuring employee contributions are pre-tax, reworking benefits, and maintaining compliance with IRS regulations. Your plan administrator will be vital in this step.

Remember, establishing a new Section 125 Plan can come with stiff upfront costs. However, be sure to consider the long-term benefits in payroll tax savings for both you and your employees.

Common Pitfalls and How to Avoid Them

Section 125 Plans can quickly become complex, especially if you have highly compensated employees or owners participating in the plans. Here are three common pitfalls to watch out for and how to avoid them.

W-2 Reporting – Certain fringe benefits need to be reported on your employee’s W-2 as taxable income. This commonly applies to owners who are enrolled in the plans. Specifically, the cost of group-term coverage above $50,000 and dependent care benefits that exceed $5,000 may adjust the employee’s W-2. S Corporation shareholders that own more than 2% of the company will also have other Section 125 benefits become taxable. Working closely with your plan administrator can help you catch these adjustments.

Nondiscrimination Testing  – IRS regulations prohibit highly compensated employees from being favored in Section 125 Plans. As a result, many companies need to complete nondiscrimination testing. Officers, shareholders owning more than 5%, and highly compensated employees and their spouses are all evaluated during the nondiscrimination testing process. Your company may need to enlist the help of an independent auditor to conduct discrimination testing according to IRS guidelines.

Contribution Requirements – Employers must make contributions to each qualified employee that is not highly compensated. This contribution can either be a uniform percentage above 2% of the employee’s compensation, or the lesser of 6% of the employee’s compensation or two times the amount of employee contributions. Monitoring your employer contributions is important to maintain compliance with this regulation.

Promoting compliant Section 125 Plans relies on working closely with professionals who understand the intricacies of IRS requirements. Handing this task off to your in-house payroll processor can open the door to errors and potential disallowance of the tax benefits for both you and your employees. This is why many companies choose to outsource Section 125 Plan management.

Conclusion

As the employment landscape continues to become competitive, offering a Section 125 Plan can be a great way to lower your payroll taxes and set your business apart from competitors. This upcoming year might be the perfect opportunity to explore and utilize a Section 125 Plan.

However, it’s important that you make employees aware of your Section 125 Plan offerings.  These plans can generate significant tax savings, but only if employees are aware of the benefits. Consider holding regular training meetings and providing employees with the necessary information and documents to enroll. Want to learn more about how you can take advantage of the Section 125 Plan and other tax incentives? Contact KDG. We have a managed accounting and tax accounting team on hand to help.

Additional Resources

Here are some additional resources to help you get started with your Section 125 Plan:

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Michele is an accomplished Accountant, bringing a wealth of knowledge and expertise to her current CPA role at KDG. Experienced in Sage Products, Tax Preparation, GAAP, Financial Accounting and Managerial Accounting. Michele has spent her career overseeing tax preparation and accounting services at a multitude of organizations, even owning her own successful CPA firm.

Want to learn more? Book a meeting with us today!

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