Offering competitive benefits attracts, satisfies, and retains top talent. In fact, 80% of employees would choose benefits over a pay raise. When you dive into different small business employee benefits, you might consider section 125 plans.
Section 125 plans give your employees the power to choose from different benefits. Learn what a section 125 plan is, how it works, and which benefits qualify.
What is a section 125 plan?
Section 125 is a written plan that lets employees choose between qualifying benefits and cash. Employees receive benefits as pre-tax deductions. Employees, their spouses, and dependents can all benefit from section 125 plans.
With pre-tax benefits, you deduct the employee’s contribution before you withhold taxes, reducing their taxable income. Typically, the employee pays less in federal income and/or FICA (Social Security and Medicare) taxes. This also lowers your FUTA tax liability.
Think of a 125 plan like a cafeteria. In a cafeteria, individuals can pick the foods they want from the selection offered. Similarly, employees can pick the benefits they want in a section 125. This is why a section 125 benefit plan is also called a cafeteria plan.
What are section 125 deductions?
You must follow the section 125 guidelines when adding benefits to your cafeteria plan. Not all benefits are included under a section 125 cafeteria plan. The benefits allowed and not allowed in a cafeteria plan are taken from the list of fringe benefits found in IRS Publication 15-B.
For the most part, you cannot include a benefit that defers an employee’s pay. However, you can include certain types of 401(k) plans and life insurance plans maintained by educational institutions.
Here are the qualifying benefits you can include in your section 125 cafeteria plan document:
- Accident and health benefits (not including Archer medical savings accounts)
- Adoption assistance
- Dependent care assistance
- Group-term life insurance coverage
- Health savings accounts (HSAs)
To determine which benefits are exempt from income, FICA, and FUTA taxes, use this chart:
Another type of benefit you can include in your cafeteria plan is a flexible spending account (FSA). However, there is a limit on these contributions. Employees can only contribute up to $2,750 to an FSA (2021 limits), or it is not considered a cafeteria plan.
These are the benefits you cannot include in your IRS section 125 plan:
- Archer MSAs
- Athletic facilities
- De minimis (minimal) benefits
- Educational assistance
- Employee discounts
- Employer-provided cell phones
- Lodging on your business premises
- Moving expense reimbursements
- No-additional-cost services
- Retirement planning services
- Transportation (commuting) benefits
- Tuition reduction
- Working condition benefits
Plans favoring employees
If your plan favors highly compensated or key employees, you must include the value of the benefits they could have selected in their wages.
A highly compensated employee is someone who is an officer or shareholder owning more than 5% of the voting power. If someone meets these descriptions, their spouse or dependents are also considered highly compensated.
A key employee in 2021 is an officer who earns an annual pay of more than $185,000 or an employee who is either a 5% owner or a 1% owner who earns more than $150,000. If more than 25% of the nontaxable benefits you provide for all employees goes towards key employees, it favors them.
Simple cafeteria plans
Some businesses can offer a simple cafeteria plan to their employees. With a simple cafeteria plan, you don’t need to worry about favoring highly compensated or key employees. You must contribute benefits on behalf of each employee.
To offer a simple cafeteria plan, you have to qualify. If you employed an average of 100 or fewer employees during either of the two previous years or if you expect to employ an average of 100 or fewer employees in the current year, you are eligible.
Employees who worked at least 1,000 hours in the previous plan year are eligible. If you want, you can exclude employees who are under the age of 21, have worked for you for less than one year, are covered under a collective bargaining agreement, or are nonresident aliens who are paid outside the United States.
For employees included under your simple cafeteria plan, you must make the same contributions for each worker. You can choose from providing:
- At least 2% of their compensation for the plan year
- At least 6% of their compensation for the plan year or twice the amount of salary reduction contributions, whichever is less
For more information on simple cafeteria plans, consult the IRS.
Creating your section 125
You must have a written section 125 cafeteria plan document before taking out pre-tax deductions. Otherwise, the IRS will think you’re not withholding enough taxes.
Your written plan must list and describe all the benefits you offer. Also, detail contribution limits for each benefit, participation rules, employer contributions, the plan year, and any other necessary information.
For help writing your cafeteria plan, turn to a professional, like a lawyer. They can help you craft your section 125 so it is accurate, legal, and understandable.
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This article has been updated from its original publish date of July 3, 2012.