A Section 125 plan, or cafeteria plan, allows employees to pay for certain benefits on a pre-tax basis. Employers use these plans to provide their employees with a choice between cash and certain qualified benefits without adverse tax consequences. Paying for benefits on a pre-tax basis reduces the employee’s taxable income and, therefore, reduces both the employee’s and the employer’s tax liability.
To receive these tax advantages, a cafeteria plan must comply with the rules of Section 125 of the Internal Revenue Code and related IRS regulations. Under these rules, a Section 125 plan must have a written plan document and can only offer certain qualified benefits on a tax-favored basis.
Once an employee makes a Section 125 plan election, they may not change that election until the next plan year, unless the employee experiences a permitted election change event. Also, for highly compensated employees to receive the tax advantages associated with a Section 125 plan, the plan must pass certain nondiscrimination tests.
Key legal requirements
To receive a federal tax advantage, Section 125 plans must comply with the following legal rules:
- must have a written plan document;
- only common law employees may participate on a pre-tax basis;
- elections are irrevocable for the entire plan year; and
- must pass certain nondiscrimination tests.
Cafeteria plan basics
A Section 125 cafeteria plan provides employees with an opportunity to pay for certain benefits on a pre-tax basis, allowing them to increase their take-home pay. Employers may also make nontaxable contributions to a Section 125 plan for their employees.
Under a Section 125 plan, employees choose between at least one taxable benefit (such as taxable compensation) and one or more qualified benefits. Qualified benefits include:
- group health plan coverage;
- vision and dental plans;
- health flexible spending accounts;
- dependent care assistance programs; and
- health savings accounts.
According to the IRS, a Section 125 plan is the only means by which an employer can offer employees a choice between taxable and nontaxable benefits without causing adverse tax consequences to the employees. To avoid taxation, the Section 125 plan must meet the specific requirements of Section 125 and underlying IRS regulations.
Tax rules: Employees who elect to participate in a Section 125 plan agree to contribute a portion of their salaries on a pre-tax basis to pay for the qualified benefits. These contributions, which are called “salary reduction contributions” are not considered wages for federal income tax purposes and are generally not subject to Social Security and Medicare tax or federal unemployment tax. This reduces employees’ taxable income, which results in savings for both employees and employers.
Steps to implement a Section 125 plan
- Adopt a written plan document that reflects the plan’s design and complies with Section 125.
- Update plan enrollment forms to include the rules for Section 125 plan elections.
- Select a vendor to perform nondiscrimination testing.
Types of Section 125 plans
There are four different types of Section 125 plans that employers can choose from when setting up their cafeteria plans:
Section 125 – Legal requirements
To qualify for tax advantages, a Section 125 plan must satisfy the requirements of Code Section 125 and underlying IRS regulations, as summarized below.
Compliance tip: Many of the benefits that may be provided through a Section 125 plan are subject to the Employee Retirement Income Security Act. ERISA includes its own set of requirements for written plan documents and summary plan description, which are different from the Section 125 plan document requirements. Employers should confirm that their employee benefit documents comply with both sets of requirements, as applicable.
Written plan document
A Section 125 plan must be maintained pursuant to a written plan document that is adopted by the employer on or before the first day of the plan year. The plan document for a Section 125 plan must include:
- a description of the benefits available through the plan, including the periods of coverage;
- the plan’s rules for employee eligibility;
- the procedures governing employees’ elections under the plan, including when elections may be made, when they are effective and any exceptions to the irrevocability rule;
- the manner for making contributions (for example, pre-tax employee contributions, employer contributions or both) and the maximum amount of contributions; and
- if the plan includes a flexible spending arrangement, a description of the special rules that apply to these accounts (for example, the uniform coverage and use-or-lose rules for health FSAs).
The plan document for a Section 125 plan may be comprised of more than one document. For example, the Section 125 plan document may incorporate by reference benefits offered through separate written plans, such as a health FSA, without describing these benefits in full. Also, other code sections require plan documents for certain qualified benefits, including a health FSA, DCAP and adoption assistance. These requirements can be satisfied by including these benefits in the Section 125 plan document.
Impact of noncompliance: According to the IRS’ 2007 proposed regulations, if there is no written plan document in place or if the written plan document does not comply with the content or timing requirements, employees’ elections between taxable and nontaxable benefits will result in taxable income to the employees.
Employers may amend a Section 125 plan at any time during a plan year. However, amendments must be made in writing and can only be effective for periods after the later of the adoption date or the effective date of the new amendment, unless otherwise permitted by the IRS.
Eligibility requirements
Any employer may sponsor a Section 125 plan for its eligible employees. This includes private sector businesses such as corporations, partnerships, limited liability companies, nonprofit organizations and public sector employers.
Also, an employer may allow any common law employee to participate in its Section 125 plan. In addition, former common law employees (for example, COBRA participants receiving severance pay) and leased employees, as defined under Code Section 414(n), may participate in an employer’s Section 125 plan.
While only employees can make elections under a Section 125 plan, a Section 125 plan may provide non-taxable benefits for an employee’s spouse, dependent child who is under age 27 or a tax dependent. A Section 125 plan cannot provide non-taxable benefits for an employee’s domestic partner who is not a tax dependent.
Relationship to health plan eligibility: An employer’s group health plan may be designed to cover individuals who do not qualify for tax-free health coverage (for example, children who are older than age 27, grandchildren or domestic partners). Under the Section 125 rules, an employee may only pay pre-tax for coverage of a spouse, a child under age 27 or a tax dependent. Coverage for other individuals should be paid for on a post-tax basis.
Although individuals who are not considered employees, such as self-employed individuals, partners in a partnership and more than 2% shareholders in a Subchapter S corporation, can sponsor a Section 125 plan for their employees, these self-employed individuals cannot participate in a Section 125 plan on a tax-favored basis. Likewise, directors of a corporation who are not also employees cannot participate in a Section 125 plan on a tax-favored basis.
Qualified benefits
A Section 125 plan must offer employees a choice between at least one taxable benefit (such as taxable compensation) and one or more qualified benefits. Benefits that are not qualified benefits cannot be offered under a Section 125 plan. The following lists commonly offered employee benefits and indicates whether they are qualified benefits that can be offered under a Section 125 plan:
- Accidental death and dismemberment (AD&D) coverage: Yes.
- Adoption assistance program: Yes. Although adoption assistance benefits provided through a Section 125 plan are not subject to federal income tax, they are subject to federal employment taxes, such as FICA and FUTA. Also, the additional Section 125 rules for flexible spending arrangements apply to adoption assistance benefits.
- COBRA coverage: Yes, if the employee has compensation that can be used to pay for coverage on a pre-tax basis.
- Dental benefits: Yes.
- DCAP: Yes.
- Disability coverage (short-term or long-term): Yes. The tax rules for payment of disability benefits depend on how premiums for the coverage are paid. DCAP premiums are paid on a pre-tax basis; disability benefits are taxed when an employee becomes disabled.
- Other fringe benefits under Code Section 132: No.
- Group health plan coverage: Yes.
- Health FSA: Yes.
- Health reimbursement arrangement: No.
- HSA: Yes.
- Individual insurance policies (major medical coverage): No. Employers may offer an individual coverage HRA to reimburse eligible employees’ individual health insurance premiums. If an individual coverage health reimbursement arrangement does not cover employees’ full premiums for individual coverage, the employer may permit employees to pay the balance of the premiums on a pre-tax basis through its Section 125 plan, provided the individual coverage is not purchased on an ACA Exchange. The Internal Revenue Code prohibits employers from allowing employees to pay for Exchange coverage on a pre-tax basis.
- Life insurance (on employee’s life): Yes, but the cost of insurance coverage more than $50,000 is taxable.
- Life insurance (on life of an employee’s spouse or dependent): No.
- Long-term care insurance: No.
- Vision benefits: Yes.
Employee elections
Prospective only
Participant elections under a Section 125 cafeteria plan must be made before the first day of the plan year or the date taxable benefits would be available, whichever comes first. Typically, employees make their elections each year during an annual open enrollment period, with the elections taking effect on the first day of the upcoming plan year. Employees who become eligible for benefits during a plan year (for example, new hires), will usually make their elections during an initial enrollment period.
There are two exceptions to the general rule that Section 125 plan elections must be made on a prospective (not retroactive) basis:
- Limited exception for new hires – Elections that new employees make within 30 days after their hire date can be effective on a retroactive basis. Elections made during this enrollment window can be effective as of the employee’s date of hire.
- HIPAA special enrollment – Special enrollment rights apply when an employee acquires a new dependent through marriage, birth, adoption or placement for adoption. When a new dependent is acquired through birth, adoption or placement for adoption, coverage must be effective retroactively to the date of birth, adoption or placement for adoption. Employees’ elections under a Section 125 plan may be retroactive to correspond with this Health Insurance Portability and Accountability Act special enrollment right.
Irrevocable for the entire plan year
Participant elections must be irrevocable until the beginning of the next plan year. This means that participants ordinarily cannot make changes to their cafeteria plan elections during a plan year. Employers do not have to permit any exceptions to the election irrevocability rule for cafeteria plans. However, IRS regulations permit employers to design their cafeteria plans to allow employees to change their elections during the plan year if certain conditions are met.
Cafeteria plans may recognize certain events as entitling a plan participant to change his or her elections (if the change is consistent with the event). Although a cafeteria plan may not be more generous than the IRS permits, it may choose to limit to a greater extent the election change events that it will recognize.
For an employee to be eligible to change his or her cafeteria plan election during a plan year, the following rules apply:
- The employee must experience a mid-year election change event recognized by the IRS.
- The cafeteria plan must permit mid-year election changes for that event.
- The employee’s requested change must be consistent with the mid-year election change event.
Employees’ mid-year election changes must be effective prospectively. The one exception to this rule is for retroactive election changes that are permissible under the HIPAA special enrollment event for birth, adoption or placement for adoption.
Some of the IRS’ mid-year election change events apply to all qualified benefits that can be offered under a cafeteria plan. However, other mid-year election change events only apply to certain qualified benefits — for example, not all the IRS’ mid-year election change events apply to elections for health FSAs.
The irrevocable election rules do not apply to a cafeteria plan’s HSA benefit. An employee who elects to make HSA contributions under a cafeteria plan may start or stop the election or increase or decrease the election at any time during the plan year, if the change is effective prospectively. If an employer places additional restrictions on HSA contribution elections under its cafeteria plan, then the same restrictions must apply to all employees. Also, to be consistent with the HSA monthly eligibility rules, HSA election changes must be allowed at least monthly and upon loss of HSA eligibility.
Permitted election change events
Cafeteria plans may recognize certain events where an employee is entitled to make election changes during a plan year. The IRS recognizes three broad categories of mid-year election change events:
- change in status events (major life events such as marriage, birth, adoption and certain employment changes);
- changes in cost or coverage for the plan’s qualified benefits; and
- other laws or court orders (for example COBRA, HIPAA and the Affordable Care Act).
Although a Section 125 plan may not be more generous than the IRS permits, it may choose to limit to a greater extent the election change events that it will recognize. An employer that recognizes one or more mid-year election change events allowed by the IRS should review its plan document to confirm that it addresses the permitted election changes. Also, employers with fully insured plans should confirm that any permitted election change events are consistent with the rules of the underlying insurance policy.
Nondiscrimination tests
Section 125 plans must pass certain tests designed to ensure that the plan does not discriminate in favor of highly compensated employees. If a cafeteria plan fails to pass nondiscrimination testing, highly compensated employees lose the tax benefits of participating in the plan (that is, they must include the benefits or compensation in their income). However, even if a cafeteria plan is discriminatory, non-highly compensated employees will not lose the tax benefits of participating in the plan. In general, a cafeteria plan must satisfy the following three nondiscrimination tests:
Certain exceptions and safe harbors apply to the cafeteria plan nondiscrimination tests. For example, a premium-only Section 125 plan is deemed to satisfy the cafeteria plan nondiscrimination requirements (the contributions and benefits test and the key employee concentration test) if it passes the eligibility test. In addition, simple cafeteria plans are treated as meeting the Section 125 nondiscrimination requirements if certain eligibility, participation and minimum contribution requirements are met.
Reporting and disclosure
Because a Section 125 plan is a tax savings arrangement, it is not subject to the reporting and disclosure requirements that apply to employee benefit plans under federal law. This means, for example, that a Section 125 plan is not required to file an annual Form 5500 with the Department of Labor and is not required to have a summary plan description. However, many of the benefits that can be purchased on a tax-free basis through a Section 125 plan (for example, a health FSA) are subject to the federal reporting and disclosure requirements for employee benefit plans, unless an exception applies.
This Compliance Overview is not intended to be exhaustive, nor should any discussion or opinions be construed as legal advice. Readers should contact legal counsel for legal advice. ©2018-2023 Zywave, Inc. All rights reserved.