The Small Business Owner’s Guide to Starting a Section 125 Cafeteria Plan

What is a Section 125 Cafeteria Plan?

A Section 125 cafeteria plan is a type of employee benefit plan that allows employees to pay pre-tax dollars for a variety of benefits.

This means that employees can elect to have a portion of their salary deducted before taxes are applied, specifically to cover the cost of their health insurance premiums. This reduces the employee’s taxable income, which in turn reduces the amount of federal, state, and sometimes local taxes owed. For the employer, it can reduce payroll taxes.

The employer provides a menu of options within the Section 125 plan. Workers can then pick and choose which benefits they want to purchase, like one would load up a lunch tray in a cafeteria.

The employer then deducts the money needed to pay premiums and other costs for the benefits selected, and pays them with pre-tax dollars on the employees’ behalf.

Note: The terms “Section 125” plan and “cafeteria” plan are used interchangeably. A section 125 plan is a separate written plan maintained by an employer for employees that meets the specific requirements of and regulations of Section 125 of the Internal Revenue Code.

Cafeteria plans also save money for employers, as well. Because employees are paying pre-tax for benefits, the money spent for these benefits does not show up as income on their W-2s. Therefore, you don’t have to pay payroll taxes on this money.

By offering a Section 125 cafeteria plan, you can help your employees save money on taxes while also providing them with a comprehensive benefits package that can help attract and retain top talent – while reducing your own payroll tax liability at the same time.

How do Cafeteria Plans Work?

In a nutshell, cafeteria plans help reduce taxes.

Here’s how it works: 

A cafeteria plan allows employees to choose between receiving taxable cash compensation or certain qualified benefits that are excluded from their  taxable income.

Instead of receiving this compensation in the form of taxable cash income, employees can choose from a menu of benefits. Examples include health insurance, dental and vision insurance, disability insurance, life insurance, and more.

Under Section 125 of the Internal Revenue Code, cafeteria plan sponsors must offer employees a choice between at least one taxable benefit (such as cash) and one pre-tax benefit (such as disability insurance).

When an employee elects to participate in a cafeteria plan, you as the employer will provide them an amount of money each year that they can use to pay for their chosen benefits via a cafeteria plan.

They then pay for these benefits via payroll deduction. That is, their premiums or fees for these benefits are deducted from their paycheck before taxes are calculated and deducted from their paychecks.

This has two benefits for the employee:

• It makes these benefits more affordable and accessible for them;
• It reduces their taxable income and lowers their tax liability.

For example, let’s say an employee earns $50,000 per year and elects to contribute $2,000 to their cafeteria plan to buy disability insurance, life insurance, and a critical illness insurance policy.

Their taxable income is then reduced to $48,000, which lowers their tax liability. If the employee is in the effective 25% tax bracket, they save $500 in income taxes.

It also means that neither you as the employer nor the employee have to pay payroll taxes on that $2,000 subject to payroll deduction.

So both you and the employee save money by reducing your tax burden.

How does a Section 125 cafeteria plan save employers money?

A cafeteria plan can save employers money in several ways.

First, it reduces payroll taxes. When employees contribute to a cafeteria plan, their contributions are exempt from federal income tax, Social Security tax, and Medicare tax. This means that the employer does not have to pay payroll taxes on the amount of money contributed to the cafeteria plan.

This alone can save more than 7% of payroll costs.

Second, a cafeteria plan can help employers attract and retain top talent. By offering a comprehensive benefits package, employers can show their employees that they value their health and wellbeing. This can lead to increased job satisfaction, higher morale, and lower turnover rates.

What Benefits Are Typically Included in Section 125 Cafeteria plans?

A Section 125 cafeteria plan can include a wide range of benefits, including:

• Health insurance premiums
• Dental insurance premiums
• Vision insurance premiums
• Disability insurance premiums
• Life insurance premiums
• Dependent care expenses
• Healthcare expenses (such as deductibles, copays, and coinsurance)

Exclusions

Section 125 plans cannot include benefits that are not considered qualified benefits under the IRS code. This includes benefits such as:

• Cash or other taxable compensation
• Stock options
• Retirement plan contributions
• Educational assistance 
• Healthsharing expenses
• Commuting expenses
• Employee discounts

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Section 125 Plans vs. FSAs

Unlike flexible spending accounts (FSAs), which are a type of reimbursement account that allows employees to set aside pre-tax dollars to pay for eligible healthcare or dependent care expenses, a cafeteria plan allows employees to use pre-tax dollars to pay for a much wider range of benefits.

Optimizing Tax Savings Using a Section 125 Plan

Integrating a Section 125 cafeteria plan with a health savings account (HSA) can be a powerful way to help your employees save money on healthcare expenses and build up savings for future healthcare needs.

Here are some best practices for integrating these two types of plans:

• Offer both plans. To integrate a Section 125 plan with an HSA, you will need to offer both plans to your employees. Your Section 125 plan can be used to pay for eligible healthcare expenses, such as insurance premiums and deductibles, while your HSA can be used to save for future healthcare expenses.

• Educate your employees. Just offering the plan isn’t enough. You also need to put emphasis on communication. Provide clear and concise communications about the benefits offered, enrollment procedures, contribution limits, and other important details. You may also want to provide educational materials or hold informational sessions to help your employees understand how the plans work and how they can use them to save money on healthcare expenses. Try to communicate benefits information throughout the year, and not just during open enrollment and onboarding. Use a variety of media, and if appropriate, provide materials in Spanish and other languages as needed.
  
  Learn more: Best Practices for Communicating Employee Benefits

• Coordinate contributions. When integrating a Section 125 plan with an HSA, it’s important to coordinate contributions to ensure that employees don’t exceed the contribution limits for either plan. You will need to establish contribution limits for both plans and ensure that employees are aware of these limits. You may also want to provide tools or calculators to help employees determine the optimal contribution amounts for each plan.

          Learn more: Higher Communication Limits Allow You To Save Even More in Taxes

• Monitor and administer the plans. Once your plans are in place, you will need to monitor and administer them on an ongoing basis. This includes processing employee contributions, coordinating with your plan administrator, and ensuring that your plans remain compliant with IRS regulations. You may also want to periodically review your plans to ensure that they are meeting the needs of your employees and your business.

By integrating your HSA offering with a Section 125 plan, you can provide your employees with a powerful tool for managing healthcare expenses and building up savings for future needs.

Types of Cafeteria Plans

There are several different types of cafeteria plans that employers can offer to their employees.  Here are some of the most common types of cafeteria plans

• Health savings account (HSA). An HSA is a tax-advantaged savings account that can be used to pay for eligible healthcare expenses. To be eligible for an HSA, an employee must have a high-deductible health plan (HDHP). HSAs allow employees to save money on taxes while also building up savings for future healthcare expenses.
• Premium-only plan (POP). A POP allows employees to pay for their share of health insurance premiums with pre-tax dollars. These plans only cover insurance premiums and no other expenditures.This can help employees save money on taxes and reduce their taxable income.
• Health flexible spending account (FSA). An FSA allows employees to set aside pre-tax dollars to pay for eligible healthcare expenses, such as deductibles, copays, and coinsurance. Employees can use FSA dollars to pay pre-tax a wide range of other healthcare expenses, including prescription drugs, glasses/contact lenses, orthodontia, dental care, mental health treatment, and even medically necessary alternative medical treatments such as acupuncture and chiropractic care.
• Dependent care flexible spending account (DCFSA). A DCFSA allows employees to set aside pre-tax dollars to pay for eligible dependent care expenses, such as daycare or afterschool care for children under the age of 13, or elderly dependents who are unable to care for themselves.
• Premium reimbursement arrangements (PRA). A PRA is similar to a POP, but it allows employees to be reimbursed for their share of health insurance premiums rather than paying for them with pre-tax dollars. PRAs can be used in conjunction with other types of cafeteria plans to provide employees with additional flexibility.
• Section 125(e) Qualified Small Employer Health Reimbursement Arrangement (QSEHRA). A QSEHRA is a type of health reimbursement arrangement (HRA) that allows small employers to reimburse employees for eligible healthcare expenses, including premiums for individual health insurance policies. QSEHRAs are available to employers with fewer than 50 full-time equivalent employees who do not offer a group health plan.

Click here for more information about HRAs, (including QSEHRAs) and how to start one.

It’s important to note that not all types of cafeteria plans are available to all employers, and eligibility requirements may vary depending on a variety of factors.

For any employers that we are helping with health insurance or health sharing benefits, we also help them with setting up their Section 125 benefits, if appropriate. For a free, no-obligation consultation on your specific situation, contact a Personal Benefits Manager.

Section 125 Compliance

Non-Discrimination Rules

To ensure that Section 125 plans benefit all employees fairly, Section 125 plan sponsors must adhere to these non-discrimination provisions.

These rules prevent business owners from setting up tax-advantaged plans that benefit themselves and senior management only, leaving rank-and-file employees out.

Should a plan violate these rules in any given year, they may be deemed discriminatory. If that happens, any benefits that were preferentially given will be considered taxable income for those high-earning or key employees who received them.

Under section 125 rules, an employee is classified as “highly-compensated” if they meet any of these criteria:

• They hold an officer position within the company;
• They own 5% or more of the company’s shares;
• They earn an annual salary that exceeds the limit specified in Sec. 414(q)(1)(B),which is $155,000 as of 2024.
• Fall within the top 20% of earners in the company, should the employer choose this classification as per Sec. 414(q)(3).

Key employees, along with their spouses and dependents, are identified as:

• For plan year 2024, officers receiving compensation according to Sec. 416(i)(1) amounting to $215,000 for the 2023 plan year are considered key employees.
• Individuals owning 1% of the company with annual earnings of $150,000 (not indexed) or more for the plan year; or
• Those owning 5% of the company or earned, no matter what they earned last year. 

Documentation Requirements

Section 125 sponsors must establish detailed written documentation for their plans.

Required documents include:

• A comprehensive plan document
• A summary document for employees

These documents must precisely define the fiscal period of the plan. Any alterations to this period must be justified by legitimate business reasons, such as synchronizing with the fiscal year of the healthcare provider. They cannot be arbitrary and only for the convenience of the employer.

The summary plan document must be distributed to all eligible employees within 90 days of their enrollment.

Detailed requirements for these documents can be found in Proposed Regulations Section 1.125-1(c).

Section 105 MERPs vs. Section 125 Cafeteria Plans

Both Cafeteria Plans and MERPs are tax-advantaged vehicles that allow employers to help employees access benefits and pay qualified medical expenses with tax-free dollars.

Contributions to both plans are fully tax-deductible to employers as a compensation expense, up to certain limits, in some cases.

Benefits under both plans are tax-free to workers. They are also exempt from payroll taxes as well as income taxes.

But there are important differences, as well. This section will dive into the differences between these two popular types of plans, and discuss when each of them may be most suitable for employers.

Let’s take a more detailed look at each of them, in turn:

MERPs

The term MERP stands for medical expense reimbursement plan.

These are established under Section 105 for the U.S. Tax Code. MERPs are IRS-approved plans under which employers reimburse qualified medical expenses of employees and their family members.

Types of Section 105 MERPs

• Healthcare Flexible Spending Account (FSAs). FSAs allow employees to contribute a portion of their salary on a pre-tax basis to an account that can be used to reimburse eligible medical expenses not covered by insurance, such as deductibles, copayments, and certain over-the-counter medications.
• Health Reimbursement Arrangement (HRA)s. HRAs are employer-funded accounts that reimburse employees for eligible medical expenses. Employers establish and fund HRAs, and employees can use the funds to pay for qualifying healthcare expenses, including deductibles, copayments, and certain medical premiums.
• Post-Retirement Medical Reimbursement Plans. These plans are designed to reimburse retired employees for eligible medical expenses incurred after retirement. Employers may set aside funds to cover medical costs for retired employees, providing a valuable benefit to help cover healthcare expenses during retirement.
• Retiree Health Reimbursement Arrangements (Retiree HRA)s. Similar to a post-retirement medical reimbursement plan, Retiree HRAs are employer-funded accounts that provide tax-free reimbursements for medical expenses incurred by retired employees. These arrangements help retirees manage healthcare costs during their retirement years.
• Self-Insured Medical Reimbursement Plan. Some employers choose to self-insure their health benefits and establish a self-insured medical reimbursement plan to reimburse employees for eligible medical expenses. These plans give employers more control over healthcare costs and may offer flexibility in plan design.

Types of Section 105 HRAs

Employers have five basic options for Section 105 HRA plans

• Integrated HRAs. Integrated HRAs are designed to work alongside a group health insurance plan. Employers can use them to reimburse employees for out-of-pocket medical expenses not covered by the group health plan, such as deductibles, copayments, and coinsurance.
• Qualified Small Employer HRA (QSEHRAs). QSEHRAs are available to small employers with fewer than 50 full-time equivalent employees who do not offer a group health plan. Employers can use QSEHRAs to reimburse employees for medical expenses, including health insurance premiums, up to a maximum annual limit set by the IRS.
• Excepted Benefit HRAs. Excepted Benefit HRAs are a type of HRA that provides limited reimbursements for certain medical expenses, such as dental and vision care, and premiums for COBRA continuation coverage, short-term health insurance, or other coverage that does not qualify as minimum essential coverage.
• Individual Coverage HRAs (ICHRAs). ICHRAs allow employers of any size to reimburse employees for individual health insurance premiums and other medical expenses. Unlike QSEHRAs, there are no limits on employer size or contribution amounts with ICHRAs. Employees must have individual health insurance coverage to participate in an ICHRA.
• Retiree HRAs. Retiree HRAs are used by employers to provide tax-free reimbursements for medical expenses to retired employees. These HRAs can help retired employees pay for health care expenses not covered by Medicare or other retirement benefits.

How Does a MERP Work? 

MERPs work differently from Section 105 Cafeteria plans in that Section 105 Cafeteria plans can be and usually are at least partially employee-funded. A MERP, in contrast, can only be funded by the employer. Employees cannot contribute to Section 105 Plan MERPs.

The MERP Process

When an employer sets up a MERP, they will establish a set monthly allowance per employee. The MERP will reimburse employees for out-of-pocket medical expenses up to that amount.

With a MERP, employers set a monthly allowance amount for each employee. That allowance represents the maximum amount an employer will reimburse the employee for their monthly healthcare expenses.

If an employee or covered dependent has a need, they purchase whatever healthcare services or goods they need, generally paying for them up front.

In some cases, depending on the type of MERP and the plan rules, employees can also buy ACA-qualified Marketplace coverage on the individual market.

Workers then submit proof of expenses to the plan, and the plan reimburses them.

Section 105 MERP benefits are pre-tax, and not subject to payroll taxes. This potentially saves workers thousands of dollars per year, and results in substantial savings for the employer, as well, thanks to the payroll tax exemption.

With Section 105, the emphasis is on reimbursing employees for the actual medical expenses they incur out of pocket.

Using MERPs to Customize Employee Health Plans

MERPs and health reimbursement arrangements (HRAs) are very similar in concept. However, MERPs have one key advantage over HRAs: Employers can “stack” multiple types of MERPs along with a single underlying health plan.

For example: You can offer employees a high-deductible health plan, which allows your workers to contribute to a health savings account, if desired.

Then, in addition to your basic health insurance plan, you can offer two MERP options to allow employees to customize their health plan to better meet their unique circumstance.

For example, one MERP plan may simply reimburse employees for deductibles under the HDHP, while another separate MERP may include reimbursement for additional benefits, such as dental and vision care and alternative medicine treatments such as chiropractic care.

It’s like allowing workers to choose pizza toppings:

Everyone likes different toppings. But everyone gets the same basic crust and tomato sauce.

The MERPs are the custom toppings on the “pizza” of your basic employer group health plan.

By using multiple MERPs to provide supplemental benefits over and above the base one-size-fits-all group health insurance plan, you can help employees with vastly different coverage needs customize your health benefits to suit their own exact circumstances. 

Eligible Medical Expenses in Section 105 Plans vs. Section 125 Cafeteria plans

Section 105 plans allow for a much broader array of reimbursable medical expenses compared to Section 125 cafeteria plans. 105-eligible plans include a wide range of expenses not covered under individual health insurance plans.

In contrast, only certain types of benefits in Section 125 plans qualify for pre-tax dollar treatment.

• Group health benefits
• Accident and disability coverage
• Adoption assistance
• Dependent care assistance
• Group-term life insurance coverage
• Health savings accounts (HSAs)

There are many other potential benefits for employees that may not be paid for with pre-tax dollars. These include:

• Long-term care insurance
• Employee discount programs
• Commuter benefits
• Gym memberships
• Minimal or de minimis benefits

MERPs vs. Health Reimbursement Arrangement (HRA)s

Health Reimbursement Arrangement (HRAs) and MERPs are very similar in concept: 

• Both allow employers to reimburse employees for eligible medical expenses with tax-free dollars.
• Both are solely employer-funded. Employees cannot contribute to either type of plan.

But HRAs have some restrictions that MERPs don’t.

• HRA rules don’t allow for  stacking multiple types of HRA plans to customize a single health plan.
• With HRAs, you can only have one arrangement per health plan.
• Qualified Small Employer HRAs (QSEHRAs) cannot be coupled with an employer-sponsored group health plan at all.

Table 1. Section 105 Plans Vs. Section 125 Cafeteria Plans

Table 2. Types of Health Reimbursement Arrangements (HRAs)

Section 125 Premium Only Plans

The premium only plan is the simplest form of a Section 125 plan and allows employees to pay their health insurance premiums with pre-tax dollars. This means that.

Unlike more comprehensive Section 125 plans that may include flexible spending accounts (FSAs) for health care and dependent care expenses, a premium only plan is limited to just the insurance premium deductions. It does not include options for pre-tax savings on other types of expenses, like medical out-of-pocket costs or dependent care costs.

Employers who offer a premium only plan must create a written plan document that outlines the benefits, establish the plan with the IRS, and adhere to certain non-discrimination tests to ensure the plan doesn’t favor highly compensated employees over others.

These plans only reimburse employees for insurance premiums, and not for anything else.

Eligibility

Section 125 Eligibility Criteria

Generally, most W-2 employees can participate in your Section 125 plan. However, the following categories of workers are not eligible to participate:

• Self-employed workers
• Partners (within the partnership)
• Shareholders with more than a 2% interest in an S-corporation

Section 105 Plan Eligibility Criteria

• Generally, anyone considered a statutory employee can participate in a 105 plan.
• Owners are not eligible – unless they are owner-employees of their own corporation or LLC.

Section 125 or Section 105: Which Should You Choose?

Both of these types of plans have advantages that are worth consideration for employers of all sizes.

But they have important differences in plan design, contribution structure, and in what types of expenses are qualified for the most favorable tax treatment.

The main difference between these two sections is in how these benefits are funded.

If you are planning on having the company pay for all these benefits, then Section 105 may be the way to go.

Section 105 allows employees to use your benefit for a much wider array of qualified medical expenses than Section 125 plans. And you as the employer still get the same tax benefits: Contributions to Section 105 plans are fully deductible to the employer, and not taxable to the employee.

This is much more tax efficient than trying to provide an equivalent value in direct cash or other taxable compensation.

The drawback to Section 105 plans is that they must be 100% employer-funded. Employees don’t get to contribute to Section 105 plans.

That’s where Section 125 Cafeteria plans have some important advantages:

Unlike Section 105 plans, Section 125 plans let employees contribute to the costs of running these plans via pre-tax payroll deductions.

This reduces taxes for the employee, reduces payroll taxes for employers, and helps provide the maximum “bang for the buck” when it comes to offering employee benefits.

Section 125 plans are extremely flexible: It’s easy for employees to pick and choose which benefits suit their lifestyle and circumstances best. So there are no worries about imposing a “one-size-fits-all” package on a diverse workforce.

And because they are employee funded rather than funded out of company coffers, Section 125 plans allow you to provide these valuable benefits at little to no cost to the employer.

How To Start a Section 125 cafeteria plan

Here’s a step-by-step guide to help you get started offering a Section 125 cafeteria plan.

• Choose a plan administrator. You will need to choose a plan administrator to manage your cafeteria plan. You can have someone do this in house, but the vast majority of small businesses outsource this function to a third-party benefits administrator.
• Determine which benefits to offer. You will need to decide which benefits to offer in your cafeteria plan. Consider surveying your employees to find out which benefits are most important to them.
• Set up your plan documents. Your plan document outlines the terms and conditions of your cafeteria plan. It should include information on the benefits offered, eligibility requirements, enrollment procedures, and contribution limits. You can work with your plan administrator or consult with a benefits consultant or attorney to help you draft your plan documents.
• Communicate the plan to your employees. Once your plan is in place, you will need to communicate it to your employees. Provide them with information on the benefits offered, enrollment deadlines, and contribution limits. You can also offer educational materials or hold informational sessions to help your employees understand how the plan works and how they can maximize their benefits.
• Monitor and administer the plan. Once your cafeteria plan is up and running, you will need to monitor and administer it on an ongoing basis. This includes processing employee contributions, coordinating with your plan administrator, and ensuring that your plan remains compliant with IRS regulations.

What documents do you need to start a Cafeteria plan?

To start a cafeteria plan, you will need to have several documents in place. Here are some of the most important documents you will need:

• Plan document. A plan document is a legal document that outlines the terms and conditions of your cafeteria plan. It should include information on the benefits offered, eligibility requirements, enrollment procedures, contribution limits, and other important details. Your plan document should also comply with IRS regulations and other applicable laws.
• Summary plan description (SPD). An SPD is a document that summarizes the key features of your cafeteria plan in plain language. It should be written in a way that is easy for employees to understand and should include information on the benefits offered, enrollment procedures, contribution limits, and other important details.
• Enrollment forms. You will need to provide employees with enrollment forms that they can use to elect the benefits they want to participate in. Your enrollment forms should include clear instructions on how to enroll and should collect all the necessary information from employees, such as their name, address, social security number, and benefit elections.
• Employee communications. You should provide employees with clear and concise communications about your cafeteria plan, including information on the benefits offered, eligibility requirements, enrollment procedures, and contribution limits. You may also want to provide educational materials or hold informational sessions to help your employees understand how the plan works and how they can maximize their benefits.
• Plan administration agreements. If you are using a third-party administrator to manage your cafeteria plan, you will need to have a plan administration agreement in place. This agreement should outline the roles and responsibilities of both parties and should include information on fees, services, and other important details.
• IRS forms. You will need to file various IRS forms to establish and maintain your cafeteria plan, including Form 5500, Form 5500-SF, Form 5500-EZ, and Form 1095-C. You may also need to file additional forms depending on the type of plan you offer and other factors.

Note: The documents required to start a cafeteria plan may vary depending on the type of plan you offer and other factors. Employers should consult with a benefits consultant or tax professional to ensure that they have all the necessary documents in place to establish and maintain their cafeteria plan.

If you already use a major payroll vendor, such as ADP, they can help you with the requirements to start a cafeteria plan for your small business.

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