Section 125 Plan Pros and Cons: Is It the Right Fit for Your Business?

A Section 125 cafeteria plan is a powerful tool that allows employees to pay for health insurance, medical expenses, and dependent care with pre-tax dollars. At the same time, employers benefit from payroll tax savings and improved employee satisfaction.

However, before implementing a Section 125 plan, businesses must consider both the advantages and potential drawbacks to determine whether it is the right fit. This guide breaks down the pros and cons of Section 125 plans, helping employers make an informed decision.

 

What Is a Section 125 Plan?

A Section 125 plan, also known as a cafeteria plan, allows employees to contribute pre-tax earnings toward certain benefit expenses, including:

• Health insurance premiums
• Flexible Spending Accounts (FSAs)
• Dependent Care Assistance Programs (DCAPs)

Employers also save money on payroll taxes since pre-tax deductions reduce taxable wages.

For more details on how a Section 125 plan reduces payroll taxes, read How Do Employers Calculate Payroll Tax Savings with a Section 125 Plan?.

Pros of Offering a Section 125 Plan

Payroll Tax Savings for Employers

One of the biggest advantages of a Section 125 plan is that it lowers employer payroll taxes. Since employee contributions are pre-tax, employers save on FICA and FUTA taxes, amounting to:

• $600 - $700 per employee per year in payroll tax savings.

Increased Employee Take-Home Pay

Employees who participate in a Section 125 plan pay less in federal, state, and Social Security taxes, leading to:

• Higher net take-home pay
• More affordable healthcare and dependent care

By reducing taxable wages, employees keep more of their paycheck while still paying for essential benefits.

Attracts and Retains Employees

With today’s competitive job market, employers need strong benefits to attract top talent. A Section 125 plan:

• Makes healthcare and dependent care more affordable for employees
• Enhances benefits without increasing wages, reducing employer costs
• Improves employee satisfaction and retention, lowering turnover rates

Tax-Free Dependent Care Benefits

A Dependent Care FSA (DCFSA) under a Section 125 plan allows employees to set aside up to $5,000 per household tax-free for child care or elder care expenses.

For companies with a large workforce of working parents, offering a pre-tax dependent care benefit can be a major perk.

IRS-Approved Compliance and Structure

A Section 125 plan is fully IRS-compliant, meaning:

• Employers reduce tax liability legally
• Employees gain access to tax-free benefits without risk
• The plan follows established guidelines, ensuring regulatory compliance

For details on IRS rules, read IRS Section 125 Plan Rules: What Employers Need to Know.

 

Cons of a Section 125 Plan

Strict Enrollment and Contribution Rules

Employees must select their benefits during open enrollment, and changes are not allowed mid-year unless they experience a Qualifying Life Event (QLE), such as:

• Marriage or divorce
• Birth or adoption of a child
• Loss of other health coverage

Without a QLE, employees are locked into their pre-tax elections for the entire plan year.

Use-It-or-Lose-It Rule for FSAs

Flexible Spending Accounts (FSAs) under Section 125 plans do not allow unlimited fund rollovers. Employees must:

• Use their FSA funds within the plan year, or
• Take advantage of a grace period or limited carryover option (if allowed by the employer)

If employees do not use all their FSA contributions, they risk losing those funds.

Nondiscrimination Testing Requirements

To remain IRS-compliant, Section 125 plans must pass annual nondiscrimination testing (NDT) to ensure:

• The plan does not favor highly compensated employees (HCEs)
• All eligible employees have fair access to pre-tax benefits

If the plan fails nondiscrimination testing, tax advantages may be revoked for highly compensated employees, increasing their taxable income.

Administration and Compliance Costs

While Section 125 plans offer tax savings, they also come with administrative costs, including:

• Plan setup fees (typically $400 - $1,000)
• Ongoing administration fees ($50 - $500 per month)
• Annual compliance testing costs ($100 - $1,000)

For a full cost breakdown, read What Are the Costs of Administering a Section 125 Plan?.

 

Is a Section 125 Plan Right for Your Business?

A Section 125 plan is ideal for businesses that:

• Want to reduce payroll taxes and improve cash flow
• Need affordable ways to enhance employee benefits without raising salaries
• Have employees who value pre-tax savings on health and dependent care expenses
• Can handle compliance testing and administrative requirements

A Section 125 plan may not be the best fit if:

• The company does not have enough employees to justify the administrative costs
• Employees prefer more flexible benefit structures than pre-tax elections allow
• The business cannot comply with IRS nondiscrimination testing requirements

 

FAQs

Can any business offer a Section 125 plan?

Most businesses can implement a Section 125 plan, but sole proprietors, partners, and S-corp owners with a 2% or greater stake are generally not eligible for pre-tax benefits.

How much does a Section 125 plan save employers?

Employers save approximately $600 - $700 per employee per year in payroll taxes by reducing taxable wages.

Can employees change their Section 125 elections mid-year?

No, unless they experience a Qualifying Life Event (QLE) such as marriage, childbirth, or loss of other coverage.

Do Section 125 plans affect Social Security benefits?

Yes, since pre-tax deductions reduce taxable wages, they also lower Social Security contributions slightly. However, the short-term tax savings typically outweigh the minor long-term impact.

What happens if an employer fails Section 125 nondiscrimination testing?

If a plan fails IRS testing, highly compensated employees may lose their pre-tax benefits and must pay taxes on their contributions.

 

Start Saving Today

A Section 125 plan is a cost-effective way to enhance employee benefits while reducing payroll taxes. If your business is looking for an affordable way to maximize tax savings, a Section 125 plan may be the perfect fit. Get a free proposal today!

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