Section 125 cafeteria plan: What it is and how to implement it in your business

Salary alone isn’t enough to attract top talent. To stand out, you need to offer a robust benefits package that goes beyond the basics. It’s the key to recruiting high-calibre candidates and retaining the best employees.

According to an employee benefits study by Fractl, more than 80% of job seekers said they give some or heavy consideration to certain benefits. For employees, benefits are essential to quality healthcare, comfortable retirement savings, and much more.

Benefits are also important for businesses as they significantly enhance job satisfaction and overall employee experience, making it essential for HR managers to stay informed about the various options available. 

In this guide, we’ll explore the section 125 cafeteria plan as a potential addition to your organization's employee benefits package. At its core, it allows employers to provide employees with flexible, tax-advantaged benefits that improve their compensation packages without increasing costs. Read on to learn more about section 125 cafeteria plans, how they work, the benefits they include, and how to implement one in your business.

What is a section 125 cafeteria plan?

A section 125 cafeteria plan is an employer-sponsored benefit plan that allows employees to choose from a variety of pre-tax benefits, effectively reducing their taxable income. The plan is named after the relevant section of Internal Revenue Service (IRS) code. It offers employees a selection of pre-tax benefits, similar to picking items from a buffet. 

Any employer subject to US income taxes can sponsor a section 125 plan. This includes sole proprietorships, partnerships, LLCs, C corporations, and S corporations. 

Section 125 benefits can include options like insurance plans, retirement plans, health savings accounts (HSAs), and more. Employees can customize their choices based on their needs and preferences and even choose not to take any benefits.

The plan enables employees to allocate a portion of their salary pre-tax to pay for qualified benefits, which are not considered wages for federal income tax purposes. To be considered a cafeteria plan, employees must be able to choose between taxable and qualified benefits. 

This framework benefits employees by lowering their taxable income and provides employers with tax advantages by reducing payroll taxes like FICA (Federal Insurance Contributions Act) and federal unemployment tax (FUTA). 

Types of section 125 plans

Section 125 cafeteria plans provide employers with a flexible way to improve employee benefits while also offering tax benefits. Section 125 plans come in several forms, each catering to different needs and organizational structures. Here are some of the most common types: 

1. Premium-only plan (POP)

A premium-only plan is a type of section 125 benefit plan that allows employees to use pre-tax dollars to pay for group health plan insurance premiums. This plan is designed to cover health insurance premiums for medical expenses, dental, vision, and certain life insurance policies. Unlike other cafeteria plans, POPs restrict the use of funds to monthly health plan insurance premiums, making them a great option for employers looking to simplify their benefits offerings.

2. Flexible spending accounts (FSA)

Flexible spending accounts allow your employees to set aside pre-tax dollars for qualified medical expenses or dependent care. These plans have an annual contribution limit and unused funds are usually forfeited at year-end. FSAs provide employees with a flexible way to manage healthcare and childcare expenses using tax-free money, which can significantly reduce their taxable income.

3. Full flex plans

Full flex plans allow eligible employees to purchase benefits using company contributions. Benefits not fully covered by the employer may be paid by the employee through payroll deductions. Full flex plans offer employees a wide range of options since they can choose from various benefits and pay for them using pre-tax dollars, maximizing their tax savings.

4. Simple cafeteria plans

Simple cafeteria plans are designed for employers with 100 or fewer employees. These plans provide protection from non-discrimination testing if they offer equal benefit contributions to all eligible employees. This makes them particularly appealing to smaller businesses looking to simplify their benefits administration while ensuring compliance with IRS regulations. 

What benefits are included in section 125 plans? 

Section 125 plans cover a range of benefits that employees can choose from, depending on their needs. Here are some of the benefits included and excluded from these plans:

Covered benefits 

The IRS considers the following benefits qualified under section 125:

• Group health benefits (e.g., medical, dental, vision)
• Accident and disability coverage
• Adoption assistance
• Retirement deposits 
• Health savings accounts (HSAs)
• Group Term Life Insurance
• Dependent Care Assistance

Non-covered benefits 

While some benefits are not covered under section 125, employers can still offer them. However, these benefits cannot be paid for with pre-tax dollars. Here are a few examples:

• Long-term care insurance
• Gym memberships
• Commuter benefits
• Work cell phones
• Education assistance

Section 125 plans deductions 

Section 125 cafeteria plans offer deductions that your employees can use to contribute pre-tax gross earnings towards various benefits, lowering their taxable income and reducing their taxes. Because contributions are made pre-tax, employees are not required to pay federal income tax on these amounts. These contributions are typically not subject to FICA taxes (Social Security and Medicare) for participating employees. 

These deductions also benefit employers by reducing payroll taxes. Since employee contributions are made before taxes, employers do not have to pay FICA or federal unemployment taxes on contribution amounts. Depending on your location, there may also be some state and local tax savings.

Section 125 cafeteria plan: 7 pros and cons

Section 125 plans can boost employee satisfaction and retention while also providing tax savings for both the employer and employee, but they might not be right for every business or situation. Let’s look at the key pros and cons for employers to consider before rolling out a cafeteria plan:

Pros

Tax savings: Cafeteria plans enable employers to reduce payroll taxes, such as FICA and federal unemployment taxes, by lowering their employee’s taxable wages through pre-tax contributions.

Flexibility in benefits selection: Allowing employees to customize their benefits package to their needs helps boost workplace engagement.

Enhanced employee retention: By offering desirable and customizable benefits, your organization becomes more attractive to potential and current talent, helping to improve employee retention. 

Increased productivity: Employees who are healthy and financially stable tend to be more productive.

Cons

Initial setup fees: Section 125 plans can be complex to set up and typically come with additional costs.

Compliance requirements: Employers must ensure their plans comply with strict IRS rules, including non-discrimination testing and accurate reporting.

Risk of loss for health FSAs: Employers offering health FSAs bear some risk of loss due to the uniform coverage rule, which requires that the full amount elected by the employee be made available throughout the plan year.

How to set up your section 125 cafeteria plan: 7 steps

When setting up a section 125 cafeteria plan, HR professionals must consider several key elements to ensure compliance and effective implementation. Here's a step-by-step guide to help you create a section 125 plan:

Step 1. Determine eligibility

Identify which employees are eligible to enroll in your plan. In most cases, eligibility is linked to defined criteria, like employment status or time worked.

Step 2. Gather the required documentation for the IRS

Create a document that outlines the terms and conditions of your plan. It should include details of the benefits you’re offering, eligibility requirements, enrollment procedures, employee contribution amounts and limits, and any additional documentation required by the IRS. Ensure the plan complies with IRS regulations and make the document available to employees upon request.

Step 3. Conduct non-discrimination tests 

Non-discrimination tests may be necessary to ensure that your plan meets IRS requirements. These tests may include an eligibility test, a benefits and contributions test, and a test to confirm that your plan does not favor any particular segment of your workforce (e.g., key or highly compensated employees). Failure to pass these tests can result in some employees losing the tax-free status of their benefits and potential penalties for the employer.

Step 4. Implement payroll adjustments

Your payroll system will require adjustments to support and calculate salary reduction contributions and other provisions of the section 125 plan. This will involve establishing procedures for your workforce to make pre-tax contributions and confirming those contributions are not taxed as wages.

Step 5. Notify employees

Notify all eligible employees about the plan's availability and provide enrollment information.

Step 6. Regularly review and update documents 

After implementing your plan, keep your plan’s documents compliant with any changes to IRS regulations and update them to reflect any changes in the benefits you offer.

Step 7. Hire an administrator

Setting up and managing section 125 plans can be difficult and time-consuming. Consider using a third-party administrator, like Rippling, to oversee your plan and handle reimbursements.

Section 125 IRS rules 

When establishing and administering section 125 cafeteria plans, understanding IRS rules and regulations is critical for maintaining compliance and ensuring things run smoothly. Here is a general overview of the IRS rules for these plans: 

Employers are required to create a written document outlining the plan's terms and conditions, including the benefits offered, eligibility requirements, and enrollment procedures. Organizations must make sure contributions are deducted before taxes and that only IRS-approved benefits are offered. Additionally, section 125 plans must also pass non-discrimination tests, if required.

The IRS's uniform coverage rule for health flexible spending accounts (FSA) under section 125 requires that the full annual amount elected by an employee be available for reimbursement on the first day of the plan year. This means that even if employees haven't fully contributed to their FSA through payroll deductions, they can still use the entire elected amount for eligible expenses throughout the year. The same rule applies to limited-purpose FSAs, which typically cover dental and vision expenses. These rules ensure that employees have consistent coverage throughout the plan year.

Another key IRS rule is the "use-it-or-lose-it" policy. The rule stipulates that employees must use their FSA funds by the end of the plan year or risk forfeiting them. However, the IRS allows plans to modify this rule by either offering a grace period or allowing a portion of the balance to be carried over to the following year.

How to calculate a section 125 cafeteria plan

Calculating a section 125 cafeteria plan involves several steps that help employers manage employee benefits efficiently while ensuring compliance with tax regulations. Here’s a step-by-step guide to assist in the process.

Step 1. Calculate employee gross earnings for the pay period

Start by determining the gross earnings of each employee for the current pay period. This includes wages, salaries, and any other forms of compensation before any deductions.

Step 2. Deduct section plan contributions from gross income

Next, deduct the employee's contributions to the cafeteria plan from their gross income. These contributions are made pre-tax to reduce the employee's taxable income.

Step 3. Withhold the applicable federal, state, and local taxes from taxable income

After deducting the cafeteria plan contributions, withhold the applicable federal, state, and local taxes from the remaining taxable income. This ensures that employees are taxed only on the income not assigned to pre-tax benefits.

Step 4. Calculate employer tax liabilities for FICA and unemployment taxes

Calculate the employer's tax liabilities for FICA and federal and state unemployment taxes. Since section 125 contributions are generally exempt from these taxes, this step helps employers save on payroll taxes.

Step 5. Remit payments to government agencies and insurance providers

Finally, remit the required payments to insurance providers for the selected benefits and to federal and state agencies for taxes. This helps make sure employee benefit plan and tax obligations are met on time.

Streamline benefits management with Rippling

Rippling's Benefits Administration software consolidates all your benefits—medical, FSA, HSA, dental, 401(k), commuter benefits, and more—into one system, automating enrollment, deductions, and administration. With Rippling, you can create the perfect employee benefits package, including section 125 cafeteria plans.

With Rippling, you can:

• Automate new hire enrollment, open enrollment, reporting, and many compliance tasks
• Easily and automatically report your insurance coverage information to the IRS and relevant state agencies
• Generate and send the required IRS forms (e.g., 1095-C) to your employees
• Track all your compliance information, including plans that were offered, insurance-eligible employees, enrollment information, and more—all in one place

You can even bring your current coverage and connect it to Rippling’s Benefits Administration software—coverage is fully transferred and managed in less time than it takes to make a coffee run.

Rippling automates benefits management for businesses of all sizes, streamlining administration, ensuring compliance, and creating a seamless experience that keeps employees engaged and valued. Rippling makes benefits administration easy so your HR team can focus on important work.

Section 125 cafeteria plan FAQs

Can employers contribute to a section 125 plan?

Yes, employers can contribute to a section 125 plan. However, these contributions must be outlined in the plan document and comply with non-discrimination rules to ensure fairness for all employees. Contributions made through a section 125 plan are not subject to comparability rules, which makes them a more flexible option for employers than making contributions outside of such a plan. 

Are there limits on how much can be deducted pre-tax?

Yes, there are limits on how much can be deducted pre-tax under a section 125 plan. The specific contribution limits for these benefits are subject to annual adjustments. 

Health flexible spending arrangement (FSA): For 2025, employees can contribute up to $3,300 through salary reductions. If the plan permits, unused amounts up to $660 can be carried over to the following year.

Dependent care FSA: For 2025, the maximum pre-tax contribution is $5,000 for single filers or married couples filing jointly and $2,500 for married individuals filing separately.

Health savings account (HSA): While contributions to an HSA can be made through a section 125 plan, the annual contribution limits are determined separately. For 2025, the limits are $4,300 for individual coverage and $8,550 for family coverage. Individuals aged 55 and older can make an additional catch-up contribution of $1,000. 

Can a section 125 plan include retirement benefits?

A section 125 plan can include certain types of retirement benefits, but it is not typically used for traditional retirement plans (e.g.,401(k)). Employers can offer retirement-related benefits through a section 125 plan, such as allowing employees to allocate pre-tax dollars towards retirement savings accounts, although this is less common. In general, section 125 plans focus on health insurance premiums, FSAs, and other qualified benefits. 

What is the difference between a cafeteria plan and a section 125 plan?

Employers often use the terms "cafeteria plan" and "section 125 plan" interchangeably, but they are not exactly the same thing.

What is a cafeteria plan? It’s a type of benefits plan that lets employees choose from taxable and non-taxable options. 

What is a section 125 plan? It’s a specific type of cafeteria plan that follows Internal Revenue Code 125 rules, allowing employees to select benefits on a pre-tax basis. These plans also define section 125 deductions. 

While every section 125 plan is a cafeteria plan, not all cafeteria plans meet section 125 requirements.

This blog is based on information available to Rippling as of March 3, 2025.

Disclaimer: Rippling and its affiliates do not provide tax, accounting, or legal advice. This material has been prepared for informational purposes only, and is not intended to provide or be relied on for tax, accounting, or legal advice. You should consult your own tax, accounting, and legal advisors before engaging in any related activities or transactions.