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Section 125 Plans – Do You Need One?

Many employers struggle with the challenge of providing an attractive compensation package at an affordable price. One tool available to meet this challenge is the Section 125 plan. Section 125 plans are also commonly referred to as cafeteria plans. While there are different types of Section 125 plans, each provides the opportunity to save money by reducing both the employer’s and employees’ tax liability. A Section 125 plan allows employers to provide their employees with a choice between cash and certain qualified benefits without adverse tax consequences. Without a Section 125 plan, employee contributions can only be made with after tax dollars.

The three basic forms of Section 125 plans are:

•             Premium Only Plan;

•             Flexible Spending Account; and

•             Full Cafeteria Plan.

What is a Premium Only Plan?

The Premium Only Plan is the most basic type of Section 125 plan and the most popular. A Premium Only Plan allows employees to pay their portion of insurance premiums with pre-tax dollars, which in turn reduces both the employer’s and employees’ tax liability. Benefits that are typically offered within a Premium Only Plan include: health, dental, vision, accidental death and dismemberment and group term life insurance.

What is a Flexible Spending Account?

Under IRC Section 125, employees may make pre-tax contributions to a Flexible Spending Account. An employee may seek reimbursement from the Flexible Spending Account for expenses paid for child care, health plan deductibles and eligible medical expenses not otherwise covered under a health plan. A Flexible Spending Account allows an employee to increase his or her spendable income while also reducing the employer’s tax liability.

What is a Full Cafeteria Plan?

Under a Full Cafeteria Plan, the employer makes a non-elective contribution for every eligible employee. The employees may spend the employer contribution to purchase any of the benefits offered within the Cafeteria Plan. In addition, the employee may contribute pre-tax dollars to purchase additional benefits beyond what he or she can purchase with the employer’s contribution.


For an employee, the disadvantages of participating in a Section 125 plan include:

·         An employee may not change his or her elections throughout the plan year unless he or she experiences a qualifying status change (for example, birth of a child or marriage).

·         Any unused funds remaining within a Flexible Spending Account at the end of the plan year and any applicable grace period are lost. However, employers also have the option of allowing employees to carry over up to $500 of unused funds from one year to the next. Any amount that is carried over does not count toward the maximum contribution limit.

·         While a Section 125 plan reduces the employee’s taxable income, it also may reduce other benefits. Benefits that are calculated using the employee’s income (for example, Social Security or retirement benefits) will, in turn, be reduced.

For an employer, the disadvantages of offering a Section 125 plan include:

·         While the employer reduces its tax liability, it is responsible for the cost, establishment and maintenance of the plan.

·         Employers offering a health Flexible Spending Account bear some risk of loss. The uniform coverage rule requires that the full amount elected by the employee (minus any reimbursements already paid) be made available to the employee at any time during the plan year.