The Complete Guide to Pre-Tax Section 125 Plans: Flexible Spending Accounts (FSAs) and More

Section 125 plans, commonly known as Cafeteria Plans, allow employees to pay for certain benefits with pre-tax dollars, reducing their taxable income and increasing their take-home pay. These plans are governed by IRS regulations and are widely used by businesses to offer competitive benefits while reducing payroll tax liabilities.

One of the most popular Section 125 plan components is the Flexible Spending Account (FSA), which allows employees to set aside pre-tax dollars for medical and dependent care expenses. Other benefits under Section 125 plans include premium-only plans (POP) and health savings accounts (HSAs).

This guide will cover everything businesses need to know about Section 125 plans, with a focus on FSAs, including their benefits, requirements, and best practices.

A Section 125 Cafeteria Plan is a tax-advantaged benefit program that allows employees to choose between cash compensation (taxable income) or certain qualified benefits (pre-tax deductions). By opting for pre-tax benefits, employees lower their taxable wages, leading to reduced federal income, Social Security (FICA), and Medicare taxes.

1. Flexible Spending Accounts (FSAs)
   • Medical FSAs
   • Dependent Care FSAs
2. Premium-Only Plans (POP)
   • Pre-tax payment of health, dental, and vision insurance premiums
3. Health Savings Accounts (HSAs)
   • Often paired with a high-deductible health plan (HDHP)
4. Commuter Benefits (Transit and Parking FSAs)
   • Covers transportation and parking costs for employees

FSAs are the most commonly used type of Section 125 pre-tax benefit. They allow employees to set aside a portion of their salary before taxes to pay for eligible medical and dependent care expenses.

A Medical FSA helps employees pay for out-of-pocket healthcare expenses, such as:

• Copays, deductibles, and coinsurance
• Prescription drugs
• Dental and vision care
• Over-the-counter (OTC) medications (with restrictions)
• Medical equipment (e.g., crutches, hearing aids)

A Dependent Care FSA allows employees to use pre-tax dollars to pay for eligible dependent care expenses, including:

• Daycare and preschool costs
• Before- and after-school programs
• In-home childcare (e.g., nanny)
• Elder care expenses (for a dependent adult)

For 2024, the IRS limits are:

• Medical FSA: $3,200 per year
• Dependent Care FSA: $5,000 per household ($2,500 if married and filing separately)

3. The “Use It or Lose It” Rule #

One key consideration for FSAs is the “use it or lose it” rule. Employees must use their FSA funds within the plan year or risk forfeiting unused amounts. However, employers may offer:

1. A grace period of up to 2.5 months to use remaining funds, OR
2. A carryover provision allowing employees to roll over up to $640 (2024 limit) into the next year.

A Premium-Only Plan (POP) allows employees to pay for their portion of employer-sponsored health insurance premiums pre-tax. This reduces their taxable income while lowering employer payroll tax expenses.

1. Simple and cost-effective to administer
2. Reduces employer payroll tax obligations
3. Helps employees save on federal, state, and FICA taxes
4. Works alongside other Section 125 plans

An HSA is a tax-advantaged savings account available to employees enrolled in a high-deductible health plan (HDHP). It is used for paying qualified medical expenses for the employee and their dependents.

• Individual Coverage: $4,150
• Family Coverage: $8,300
• Catch-Up Contribution (age 55+): Additional $1,000

Differences Between FSAs and HSAs:

Employers can offer commuter benefits under Section 125, which allows employees to pay for eligible transportation and parking costs pre-tax.

• Transit FSA: $315 per month
• Parking FSA: $315 per month

Eligible expenses include:

• Public transit passes (bus, subway, train)
• Parking fees for work-related parking
• Vanpooling services

• Lower taxable income, resulting in higher take-home pay
• Pre-tax savings on essential expenses like healthcare, childcare, and commuting
• Greater flexibility in benefit selection

• Lower payroll taxes (FICA, FUTA, and state payroll taxes)
• More attractive benefits package to improve recruitment and retention
• Cost-effective way to provide benefits without large direct employer contributions

Employers offering Section 125 plans must comply with IRS regulations and reporting requirements.

1. Plan Document – Employers must create and maintain a formal plan document outlining benefits, eligibility, and contribution limits.
2. Nondiscrimination Testing – Section 125 plans cannot disproportionately favor highly compensated employees (HCEs) or key employees.
3. Annual Enrollment Period – Employees can only make changes during open enrollment unless they experience a qualifying life event (e.g., marriage, birth of a child).
4. COBRA Compliance – Employers with 20+ employees must offer continuation coverage for FSAs under certain conditions.

Decide whether to offer an FSA, HSA, POP, commuter benefits, or a combination.

A written plan document must detail:

• Employer and employee contributions
• Covered benefits
• Plan rules and compliance measures

Consult with a third-party administrator and/or an ERISA attorney to draft your plan document.

Most companies partner with third-party administrators (TPAs) or payroll providers to handle plan administration, reimbursements, and compliance.

Educate employees on how the plan works, contribution limits, and eligible expenses. This is typically done during annual open enrollment, for new hires, and during qualifying life events.

Employers must conduct annual nondiscrimination testing to ensure the plan does not disproportionately favor highly compensated employees (HCEs) or key employees (owners or executives). The three primary tests include:

• Eligibility Test – Ensures that a reasonable percentage of non-highly compensated employees (NHCEs) are eligible.
• Benefits and Contributions Test – Verifies that benefits and employer contributions are fair and consistent.
• Key Employee Concentration Test – Ensures that key employees do not receive more than 25% of total plan benefits.

Failure to pass these tests may result in plan disqualification and taxation of benefits for affected employees.

The IRS requires a written plan document detailing rules, benefits, and eligibility. Without it, the plan is not legally compliant.

If a Section 125 plan favors executives or high earners, the IRS may disqualify the plan, leading to tax penalties.

Many employees underfund their FSAs or forget to use them due to lack of education. Employers should:

• Offer training and guidance on how FSAs work.
• Send reminders about upcoming deadlines.
• Provide examples of eligible expenses.

Section 125 plans have strict rules on when employees can modify their elections. Changes are only allowed for qualifying life events (e.g., marriage, divorce, birth of a child). Employers should ensure they follow IRS guidelines.

Employers can allow a $640 rollover or a 2.5-month grace period to prevent employees from losing unused funds. Not offering this flexibility may lead to employee frustration and reduced participation.

A Section 125 cafeteria plan can be a powerful tax-saving tool for both employers and employees. It enhances employee benefits, reduces payroll taxes, and provides a flexible approach to healthcare and dependent care expenses.

If your business has 50+ employees and offers health benefits, adding an FSA, HSA, POP, or commuter benefits can make your compensation package more attractive while saving on FICA and payroll taxes.

✔ Review your current benefits plan to see if a Section 125 plan fits your strategy.
✔ Work with a third-party administrator (TPA) to ensure compliance and ease of administration.
✔ Educate employees on how these plans work to maximize participation and satisfaction.

Implementing a Section 125 plan is a smart financial move for businesses that want to stay competitive while helping employees manage healthcare and childcare costs tax-free.