Employers can have difficulty enticing and retaining talented workers in today’s tight labor market. One way to make your business more attractive is by offering a top-notch employee benefits package that includes a health benefit.
While traditional group health insurance can be too costly for many small to mid-sized companies, a Section 125 premium-only plan (POP) may be more accessible. This health benefit solution can help you boost your compensation package without blowing your budget.
Before taking advantage of a Section 125 plan and its tax benefits, you must know how to set up and offer one compliantly to avoid penalties. In this article, we’ll take you through a deep dive into Section 125 plans and their rules and regulations.
Takeaways from this blog post:
- Section 125 plans allow employees to receive a portion of their compensation on a pre-tax basis to pay for qualified benefits. These benefits include premium-only plans, flexible spending accounts, simple cafeteria plans, and full-flex cafeteria plans.
- Section 125 plan documents should include information about the plan year, available benefits, eligibility, and the process for making pre-tax elections. Working with a third-party administrator or tax advisor can help ensure compliance with plan document requirements and avoid penalties.
- Employees generally make Section 125 plan elections during open enrollment. Still, they can change their elections during the plan year if they experience an IRS-recognized mid-year election change event. Additionally, these plans must pass certain nondiscrimination tests to ensure they’re fair to non-highly compensated employees.
Named after Section 125 of the Internal Revenue Code1, a Section 125 plan allows employees to take a taxable portion of their total compensation—most often their cash wages—and receive it on a pre-tax basis to pay for qualified benefits.
With these plans, employees “elect” the total amount of pre-tax money they want their employer to withhold from their income for the plan year. The employer distributes this amount equally between their paychecks.
For example, an employee may elect to have $900 per year deducted from their income. If they receive a paycheck bi-monthly, the employer will deduct $37.50 from each paycheck on a pre-tax basis, which they can then allocate toward qualified benefits.
Examples of Section 125 plans include:
Because Section 125 plans use pre-tax dollars, employees enrolled in them pay less federal income, Medicare, and Social Security taxes. This can equal tax savings between 20% to 40%, depending on where they live. These plans also save employers an extra 7.65% on their payroll taxes.
Like most fringe benefits, employers can’t require employees to participate in a Section 125 plan.
Understanding Section 125 plan rules for POPs can be difficult if it’s your first time. But it’s vital to ensure you follow all the requirements to avoid compliance issues and receive your full tax advantages.
The sections below will help guide you through the strict rules and regulations for Section 125 plans.
A main component of maintaining your Section 125 POP is creating and adopting the necessary plan documentation. These documents include a main plan document, an adoption agreement, and a summary plan description (SPD).
The main document and the adoption agreement outline what the plan offers, qualified benefits, and your legal obligations. You can include the adoption agreement in the main plan document or separate them. You must adopt these documents on or before the first day of the plan year.
Plan participants must receive a copy of the plan documents every 10 years if you don’t update the plan’s details. If you’ve updated the plan, participants should receive a copy every five years.
Your Section 125 plan documents should include the following:
An SPD is a summary of your benefit plan that highlights the benefit’s details and requirements in plain language for your employees. You must provide the SPD to all eligible employees within 90 days of their first date of coverage under the plan.
Some of the benefits you offer through your Section 125 plan may have to follow the Employee Retirement Income Security Act (ERISA) requirements regarding plan documents and SPDs, which differ from Section 125 regulations. You must check which benefits must follow multiple plan document requirements to ensure you remain compliant.
Working with a third-party administrator (TPA), tax advisor, or legal counsel to draft your plan documents can help you navigate potential compliance issues and avoid costly penalties.
Employees should receive a salary-reduction agreement before enrolling in a Section 125 POP. A salary-reduction agreement is a document in which the employee agrees to accept a lower salary in exchange for contributing pre-tax money—also called “salary reduction contributions” or “elections” toward their Section 125 plan.
By signing, employees opt-in to their plan and acknowledge that their employer will make pre-tax deductions from each paycheck for qualified benefits.
Current or former employees are eligible to participate in a Section 125 plan. Only enrolled employees can make contributions to the plan. However, an employee’s spouse, dependent child under age 27, or other qualified dependent can receive qualified benefits through the plan.
Any company with employees subject to U.S. income taxes can sponsor a Section 125 plan, including a:
Self-employed individuals, partners within a partnership, and shareholders who own more than 2% of a subchapter S corporation can’t participate in a Section 125 plan.
According to the IRS, a Section 125 plan must give employees a choice between at least one taxable benefit, such as cash wages, and one or more qualified benefits. Depending on the type of benefit or the coverage amount, the taxability rules will vary.
The following qualified benefits are eligible under Section 125 plans:
Non-qualified benefits under Section 125 policies are educational assistance plans, transportation fringe benefits, certain benefits under Code Section 1322, health reimbursement arrangements (HRAs), individual major medical plans, long-term care insurance, and life insurance plans for an employee’s spouse or dependent.
Generally, employees must make Section 125 POP plan elections on a prospective basis, not retroactively. This means employees make their elections during the annual open enrollment period, with their elections taking effect on the first day of the following plan year. However, there’s an exception for new hires. New employees may make their elections retroactively within 30 days of their hire date to be effective on their original hire date.
Employees usually can’t change their elections during the plan year. However, the IRS allows employees to change their elections during the plan year if they meet certain conditions.
The following conditions must apply for an employee to change their elections mid-year:
Mid-year election changes must be effective prospectively, with one exception. Employees who acquire a new dependent through marriage, birth, adoption, or placement for adoption can make retroactive election changes under the HIPAA special enrollment rule.
Some mid-year change events will apply to all qualified benefits. However, other events only affect certain benefits. For example, employees who make HSA contributions under a Section 125 plan can start, stop, increase, or decrease the election at any time during the plan year if they make it effective prospectively.
Employers that allow mid-year election change events should include these details in their plan documents, including which benefits the change events apply to, to ensure clarity for employees. Additionally, employers with fully-insured health policies must check with their insurer to confirm that mid-year election change events comply with their health insurance plan.
Section 125 plans must pass specific tests to prove the plan doesn’t discriminate against non-highly compensated employees (NHCEs). If your plan is discriminatory, highly compensated employees (HCEs) will lose their tax advantages, meaning they must pay taxes on their qualified benefits.
NHCEs participating in the plan will still receive their tax benefits even if your plan is discriminatory.
Your plan must pass the following three nondiscrimination tests:
There are certain exceptions and safe harbors that apply to nondiscrimination tests. For example, a POP plan can satisfy the nondiscrimination requirements if it passes the eligibility test. Once you complete your tests, keep all your results on file in the event of an audit.
Section 125 plans use pre-tax contributions, so they’re generally not subject to reporting requirements that other employee benefit plans must follow, like completing Form 5500.
However, as they’re still a fringe benefit, employers can report Section 125 plan deductions on their employees’ Form W-2 in Box 14 for informational purposes. They can include deductions toward Section 125 dependent care plan benefits in Box 10. In either case, the IRS doesn’t consider these amounts taxable income for employees.
You may have to fulfill other reporting requirements depending on what benefits you offer alongside your Section 125 plan.
While POPs allow employers and employees to make pre-tax contributions to the employee portion of health insurance costs, there’s an easier way to facilitate a premium-only benefit. A health reimbursement arrangement (HRA) allows you to reimburse your employees for their qualifying medical expenses. Depending on the type of HRA you offer, this can include health insurance premiums.
With a qualified small employer HRA (QSEHRA), organizations with fewer than 50 full-time equivalent employees (FTEs) can reimburse employees for out-of-pocket medical expenses and health insurance premiums. With a premium-only QSEHRA, you can restrict eligible expenses to only insurance premiums for employees and their dependents.
Organizations of all sizes can offer an individual coverage HRA (ICHRA). However, employees must have an individual health insurance policy to participate. A premium-only ICHRA allows employers to reimburse employees for their individual health insurance premiums.
Premium-only QSEHRAs and ICHRAs can be a more flexible option than a POP.
Offering a health benefit can positively impact your employees and entice them to stay at your company long-term. With a Section 125 plan, employees can save on qualified benefits while reducing their tax liabilities. However, you must comply with Section 125 plan rules and regulations to avoid penalties.
If you’re unsure if your Section 125 plan complies with the rules, work with a tax advisor or TPA to help you create the required plan documents and implement the benefit properly to ensure you fulfill your legal responsibilities.
If you’re looking for a modern alternative to a POP, PeopleKeep can help. Our HRA administration software makes it easy to set up and manage personalized benefits in minutes.
This article was originally published on September 15, 2012. It was last updated on February 9, 2024.
1. https://www.irs.gov/pub/irs-drop/n-05-42.pdf
2. https://www.law.cornell.edu/uscode/text/26/132