Section 125 cafeteria plan is one of the most effective tools employers can use to reduce payroll taxes while offering valuable employee benefits. Yet many businesses either misunderstand how it works or fail to implement it correctly.
This guide explains what a Section 125 plan is, how it works, and why it matters for employers.
What Is a Section 125 Cafeteria Plan?
A Section 125 cafeteria plan is an employer-sponsored benefit plan that allows employees to pay for certain benefits with pre-tax dollars. The name comes from the idea that employees can choose from a menu of benefits, similar to selecting items in a cafeteria.
Under IRS Section 125, eligible benefits are excluded from federal income tax, Social Security tax, and Medicare tax. This creates savings for both employees and employers.
How Section 125 Plans Work
Instead of paying for benefits with after-tax income, employees elect to redirect a portion of their wages into qualified benefits before taxes are calculated.
For employers, this means:
- Lower employer payroll taxes
- No increase in gross compensation
- Predictable, compliant tax treatment
For employees, this means:
- Reduced taxable income
- Higher net take-home pay
- Access to benefits they may already be paying for
Common Benefits Offered Under Section 125
While the structure matters more than the benefits themselves, most Section 125 cafeteria plans include:
- Health insurance premiums
- Dental and vision premiums
- Flexible Spending Accounts (FSAs)
- Dependent care assistance
- Other IRS-approved qualified benefits
Some employers also integrate preventative care and reimbursement-based benefits when structured correctly.
Types of Section 125 Plans
There are several types of cafeteria plans, but the most common include:
Premium Only Plan (POP)
Allows employees to pay insurance premiums on a pre-tax basis. Simple and widely used.
Flexible Spending Accounts (FSA)
Allows employees to set aside pre-tax funds for medical or dependent care expenses.
Full Cafeteria Plan
Offers multiple benefit elections under one compliant framework.
The right structure depends on company size, workforce demographics, and administrative capabilities.
Why Employers Use Section 125 Plans
Employers adopt Section 125 plans primarily for tax efficiency. Each dollar redirected pre-tax reduces the employer’s share of payroll taxes.
Key employer advantages include:
- Payroll tax savings per participating employee
- Improved benefit offerings without increasing salary
- Higher employee satisfaction and retention
- Competitive advantage in hiring
For many businesses, Section 125 plans generate savings without disrupting existing payroll or benefit systems.
Compliance Basics Employers Must Know
A Section 125 plan is not automatic. Employers must follow specific IRS requirements, including:
- A written plan document
- Annual elections by employees
- Consistent administration
- Nondiscrimination testing
- Proper recordkeeping
Failure to maintain compliance can result in the loss of pre-tax status for all participants.
Is a Section 125 Plan Right for Your Business?
If your company has W-2 employees and offers any form of employee-paid benefits, a Section 125 cafeteria plan is likely worth evaluating.
The key is proper design, documentation, and ongoing compliance.
When structured and managed correctly, Section 125 plans are one of the simplest ways to reduce taxes while improving employee benefits.
