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Section125 Benefit Plans

Explore the benefits and tax implications of §125 Cafeteria Plans for employees.

§125 benefit plans and tax implications

Goals and takeaways

  • Understand the structure and purpose of §125 (Cafeteria) Plans
  • Identify which benefits qualify under §125, including FSAs and dependent care
  • Learn the tax treatment and reporting requirements for each component

What is a §125 (Cafeteria) Plan?

A §125 plan, also known as a Cafeteria Plan, allows employees to choose between receiving taxable compensation or qualified pre-tax benefits. Under this structure, employees can pay for certain benefits using pre-tax dollars, reducing their taxable income.

To qualify under IRC §125:

  • The plan must be in writing
  • All participants must be employees
  • Employees must have the choice between at least two benefits (cash or qualified benefits)

Qualified benefits under §125

The following are common qualified benefits allowed under a §125 plan:

  • Medical, dental, and vision insurance
  • Group-term life insurance (up to limits; excess may be imputed)
  • Dependent care assistance (up to annual limits)
  • Short- or long-term disability coverage
  • Flexible Spending Arrangements (FSAs)
  • Elective contributions to 401(k) plans (FICA taxable)
  • Cash in lieu of benefits (taxable)
Most employers offer either a full cafeteria plan or a POP (Premium Only Plan), which allows pre-tax deductions for insurance premiums without offering a full menu of choices.

Important restrictions

  • No deferrals (except 401(k)) are allowed
  • Benefits must be used during the plan year; unused amounts may be forfeited
  • Reimbursements cannot be issued in advance
  • Employees must authorize all deductions in writing

Tax implications

Contributions made under a §125 plan:

  • Reduce federal income tax, FICA, and FUTA taxable wages
  • May or may not reduce state or local taxable wages depending on jurisdiction
  • Must be deducted from employee compensation (wages, bonuses, PTO, etc.) to qualify as pre-tax
Deductions made outside compensation (e.g., while on unpaid leave) must be treated as after-tax.

Example

XYZ Inc. offers a $600/month benefit allowance.

  • Aaron elects:
    • $125 for STD/LTD
    • $200 for dependent care
    • $100 for health FSA
    • Declines medical coverage and receives $175 in cash in lieu (taxable)

Only the $175 is reported as taxable wages.

Flexible Spending Arrangements (FSAs)

FSAs are pre-tax accounts that allow reimbursement of qualified expenses. There are three types:

  1. Health care FSA
  2. Dependent care FSA
  3. Adoption assistance FSA (not covered in detail

FSA rules

  • Cannot reimburse insurance premiums
  • Cannot mix expense types across FSA types
  • Each FSA must operate under a defined 12-month plan year
  • Expenses must be substantiated (paper or electronic)

Health care FSA

Covers out-of-pocket medical, dental, and vision expenses (but not premiums).

Key requirements

  • Full plan year election: Employees must elect the total amount upfront
  • 2022 contribution limit: $2,850 (employers may set a lower cap)
  • Use-it-or-lose-it: Unused funds are forfeited unless the plan includes one of the following:

Grace period

  • Allows use of funds for 2.5 months after plan year ends
  • Must be included in the plan document
  • Example: Elizabeth has $200 left and uses it for expenses incurred by March 15 of the following year

Carryover

  • Allows up to $570 (2022) to roll over
  • Cannot be used in the same plan year as a grace period
  • Employers may require current-year funds to be used first

Uniform coverage

  • The full elected amount must be made available immediately
  • If an employee resigns before full repayment, the employer absorbs the loss
Example: Roger elects $2,850, uses it in January, and leaves mid-year. Only a portion is deducted before resignation, but the employer cannot accelerate repayment.

Dependent care FSA

Used for qualifying child or dependent care expenses.

Key differences

  • Reimbursements only allowed after funds are contributed
  • Annual limit: $5,000 (does not increase annually)
  • Uniform coverage does not apply

Experience gains and forfeitures

If employees do not use their full election, the employer may:

  1. Retain unused funds
  2. Apply forfeitures to:
      • Reduce contributions for the following year
      • Refund employees uniformly
      • Offset administrative costs

Reporting requirements

Forms W-2 and 941

  • Pre-tax §125 deductions reduce taxable wages on both forms
  • Dependent care FSA:
    • Up to $5,000 reported in Box 10
    • Excess amounts must also be included in Boxes 1, 3, and 5
  • Group-term life (over limits): Box 12, Code C
  • 401(k) deferrals: Box 12, Code D