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Jun 12, 2024 Erin Crowley

Section 125 Pretax Benefits for Employers and Employees

Section 125 Pretax Benefits for Employers and Employees

What if there was a way to save money on health insurance premiums while increasing your team's take-home income, leading to happier, more satisfied employees and a more positive workplace environment?

Good news: Section 125 premium only (POP) plans offer you the opportunity to do just that.

As a business owner, you understand the crucial role that health insurance plays in attracting and retaining top-quality employees. However, the rising healthcare costs can strain your company's bottom line and your employees' wallets.

That's where Section 125 plans come in. These plans, also known as Cafeteria Plans, allow employees to pay for certain benefits, such as health insurance premiums, with pretax dollars. At the same time, employers can benefit from reduced payroll taxes from their regular payroll contributions, as they are not required to pay Social Security and Medicare taxes on what they pay into the plan.

In this article, we'll explore Section 125 plans, their workings, the pretax advantages they offer you and your employees, and the steps you can take to implement one in your business.

Section 125 PreTax Benefits: The Basics 

Before diving into section 125 pretax benefits and how your business can start enjoying them, what are section 125 plans anyway? Let’s find out.

What is a Section 125 Premium Only Plan? 

Section 125 of the Internal Revenue Code lets companies establish Cafeteria Plans so employees can pay for certain benefits (like health insurance premiums, dependent care, or flexible spending accounts) with pretax dollars. 

Section 125 Premium-Only Plans are often called “Cafeteria Plans” because, like in a cafeteria, your team can choose their own options to build their ideal plan and get the most Section 125 pretax benefits.

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Pretax Benefits for Employees 

As already mentioned, one of the primary advantages of Section 125 plans for employees is reducing their taxable income. This lets employees lower their overall tax liability and increase their take-home pay, putting their hard-earned money back in their pockets. 

For example, if employees earn $50,000 annually and contribute $2,000 to a Section 125 plan for health insurance premiums, their taxable income would be reduced to $48,000, resulting in $2,000 tax savings.

Another benefit for employees is the flexibility to choose from a range of benefits that best suit their individual needs. Section 125 plans can offer various options, like health insurance, Flexible Spending Accounts (FSAs) for healthcare and dependent care, Health Savings Accounts (HSAs), and commuter benefits. 

This flexibility allows employees to tailor their benefits package to their specific situation, whether they want to prioritize health coverage, set aside funds for childcare expenses, or save money on transportation costs.

PreTax Benefits for Employers

You can also reap significant benefits from implementing a Section 125 Plan as an employer. By offering pretax benefits, you reduce payroll taxes since you don’t have to pay Social Security and Medicare taxes on what your employees contribute to the plan.

Moreover, a comprehensive benefits package with Section 125 options helps attract and retain top talent. Everyone wants great healthcare! In today’s competitive job market, these valuable benefits can set your company apart and demonstrate that you care about your team.

Section 125 Tax Exemptions

Let’s examine the tax exemptions related to Section 125 Plans more closely:

  • Federal Income Tax Exemptions: One of the primary benefits of Section 125 plans is the exemption from federal income tax on employee contributions. By contributing to a Section 125 plan, employees can lower their taxable income, resulting in substantial tax savings.
  • Social Security Tax and Medicare Tax Exemptions: Section 125 plans provide exemptions from Social Security tax (FICA) and Medicare tax for employees and employers on contributions made to the plan. This reduces the tax burden on employees and leads to payroll tax savings for employers.
  • State Tax Considerations: It's important to note that while Section 125 plans offer significant federal tax benefits, state tax regulations may vary. Employers and employees should consult with tax professionals or review state tax guidelines to understand the implications of Section 125 plans on state taxes.
  • Reduced Unemployment Taxes: Definitely federal - case by case per each state 

How To Implement a Section 125 Plan in Your Business 

If you want to start a Section 125 plan at your company, the first step is to obtain a health plan from a trusted local insurance broker. Next, you’ll have to establish a written Section 125 Plan Document outlining eligible benefits, participation rules, and administrative procedures. Your team would then need to sign salary reduction agreements, which allow them to contribute a portion of their pretax salary to pay for the selected benefits.

As an employer, it’s your job to ensure that your Section 125 plan complies with all applicable regulations and nondiscrimination rules. These rules are designed to prevent plans from favoring highly compensated employees and require that all participants have an equal opportunity to benefit from the plan.

Limitations and Considerations 

When considering Section 125 plans, it is important to keep in mind that although these plans offer benefits, there are limits. One such limitation is the "use it or lose it" rule that applies to FSAs. This means that your employees will lose any unused funds at the end of the plan year or grace period. 

Another consideration is that employees cannot change Section 125 benefits elections unless they experience a qualifying life event, like a marriage, divorce, or the birth of a child. This means they’re locked into most choices for an entire calendar year, even if their needs change, and often, these changes are the hardest to predict.

Make The Most of Your Section 125 Pretax Plan

We don’t offer Section 125 plans or health insurance plans here at ConnectPay, but we can help you find trusted, local brokers to explore your options. Or if you’ve already got a Section 125 Plan but need a Plan Document–we can help too! Our new product Connect Section 125 is an affordable vehicle to master Section 125 Plan Document compliance for your small business! Our portal and its tools can help you manage Section 125 compliance all year long. 

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Published by Erin Crowley June 12, 2024