Pre-Tax Benefits Under Section 125: Employer Setup, Limits & Best Practices

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 IRS-regulated plans are widely used by businesses to offer competitive benefits while reducing payroll tax liabilities.

With major changes coming in 2026 under the One Big Beautiful Bill Act (OBBBA), including a significant increase in Dependent Care FSA limits, employers need to understand how to structure, implement, and maintain compliant Section 125 plans.

This comprehensive guide covers everything businesses need to know about Section 125 cafeteria plans, with detailed focus on FSAs, HSAs, and the critical 2026 updates affecting employers.

What is a Section 125 Plan?

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

The term “cafeteria plan” comes from the concept of employees selecting benefits from a menu of options, similar to choosing items from a cafeteria line.

How Section 125 Plans Work

Employees elect to have a portion of their gross salary withheld before taxes to fund various qualified benefits. This reduces their taxable income while providing access to essential services like healthcare, dependent care, and commuter expenses.

Example: An employee earning $60,000 annually contributes $3,000 to a Medical FSA. Their taxable income drops to $57,000, saving approximately $750 in federal income and FICA taxes (assuming a 25% combined tax rate).

Types of Section 125 Benefits

Section 125 cafeteria plans can include several types of pre-tax benefits:

1. Flexible Spending Accounts (FSAs)

• Medical FSAs for healthcare expenses
• Dependent Care FSAs for childcare and elder care costs

2. Premium-Only Plans (POP)

Pre-tax payment of employer-sponsored health, dental, and vision insurance premiums

3. Health Savings Accounts (HSAs)

Tax-advantaged savings accounts paired with high-deductible health plans (HDHPs)

4. Commuter Benefits

• Transit FSAs for public transportation costs
• Parking FSAs for work-related parking expenses

Each benefit type has specific IRS rules, contribution limits, and compliance requirements that employers must follow.

2026 FSA Contribution Limits: Major Changes

CRITICAL UPDATE: The One Big Beautiful Bill Act (OBBBA) introduces significant changes to FSA limits effective January 1, 2026.

Updated 2026 Limits

Benefit Type	2026 Limit
Medical FSA	$3,400
Dependent Care FSA	$7,500
DC FSA (Married Filing Separately)	$3,750
HSA (Self-Only)	$4,400
HSA (Family)	$8,750
HSA Catch-Up (Age 55+)	$1,000
Transit/Parking FSA	$340/month

What This Means for Employers

The 50% increase in Dependent Care FSA limits represents the most significant change, providing substantial tax savings opportunities for working parents. Employers must:

• Update plan documents by December 31, 2025 (for calendar-year plans)
• Modify HR/payroll systems to accommodate new contribution caps
• Educate employees about increased savings opportunities during open enrollment
• Re-run nondiscrimination testing with new participation patterns

Important: The new $7,500 Dependent Care FSA limit is NOT indexed for inflation under current law, meaning it will remain at this level unless future legislation changes it.

Understanding Flexible Spending Accounts (FSAs)

FSAs are the most commonly used type of Section 125 pre-tax benefit, allowing employees to set aside pre-tax salary to pay for eligible expenses throughout the plan year.

1. Medical FSA (Healthcare FSA)

A Medical FSA helps employees pay for out-of-pocket healthcare expenses not covered by insurance.

Eligible Medical FSA Expenses:

• Medical, dental, and vision copays
• Deductibles and coinsurance
• Prescription drugs and medications
• Over-the-counter (OTC) medications and supplies
• Medical equipment (crutches, wheelchairs, hearing aids)
• Orthodontia and dental work
• Vision care (glasses, contact lenses, LASIK)
• Chiropractic and physical therapy
• Mental health counseling copays

2026 Contribution Limit: $3,400 per year

Key Features:

• Funds are available immediately at the start of the plan year (uniform coverage rule)
• Employees can use the full annual election even if they haven’t contributed the full amount yet
• Employers bear the risk if an employee leaves mid-year after using more than they contributed

2. Dependent Care FSA (DCFSA)

A Dependent Care FSA allows employees to use pre-tax dollars to pay for eligible dependent care expenses that enable them (and their spouse, if married) to work or look for work.

Eligible Dependent Care FSA Expenses:

• Daycare and preschool costs
• Before-school and after-school programs
• Summer day camps (not overnight camps)
• In-home childcare providers (nannies, au pairs)
• Elder care for dependent adults (parents, disabled relatives)
• Babysitting expenses related to work

2026 Contribution Limit: $7,500 per household ($3,750 if married filing separately)

Key Differences from Medical FSA:

• Funds are only available as they’re contributed (not uniform coverage)
• Must use funds for dependents under age 13 or disabled dependents of any age
• Care provider must have a valid Tax ID number
• Cannot be used for overnight camps or education expenses (kindergarten and above)

3. The “Use It or Lose It” Rule and Employer Options

One critical 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 one of the following options (not both):

Option 1: Grace Period

• Allows employees up to 2.5 months after the plan year ends to incur expenses
• Example: For a calendar-year plan, employees have until March 15 to use previous year’s funds
• Any remaining balance after the grace period is forfeited

Option 2: Carryover Provision

• Medical FSA: Allows rollover of up to $640 (2024 limit, expected to increase for 2026)
• Dependent Care FSA: No carryover permitted by IRS regulations
• Carried-over amounts don’t count toward the next year’s contribution limit

Best Practice: Most employers offer the carryover option for Medical FSAs to reduce employee frustration and increase participation rates.

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Premium-Only Plans (POP)

A Premium-Only Plan (POP) is the simplest type of Section 125 plan, allowing employees to pay their portion of employer-sponsored health insurance premiums with pre-tax dollars.

Key Benefits of a POP

For Employees:

• Reduces taxable income
• Saves on federal income tax, FICA, and state taxes
• Simple to use—automatic payroll deduction

For Employers:

• Lower FICA tax obligations (7.65% savings on employee contributions)
• Cost-effective to administer
• Can be implemented alongside other Section 125 benefits
• Minimal compliance burden compared to FSAs

Example Savings: An employee pays $200/month for health insurance premiums. With a POP:

• Annual premium: $2,400
• Tax savings (25% bracket + 7.65% FICA): ~$784/year
• Employer FICA savings: ~$184/year

POP Implementation Requirements

While POPs are simpler than FSAs, they still require:

• A written Section 125 plan document
• Nondiscrimination testing
• Annual enrollment process
• Documentation of qualifying life events for mid-year changes

Health Savings Accounts (HSAs) Under Section 125

An HSA is a tax-advantaged savings account available to employees enrolled in a qualifying high-deductible health plan (HDHP). HSAs offer triple tax benefits: contributions are pre-tax, earnings grow tax-free, and withdrawals for qualified medical expenses are tax-free.

2026 HSA Contribution Limits (Updated)

Coverage Type	2026 Limit
Self-Only Coverage	$4,400
Family Coverage	$8,750
Catch-Up (Age 55+)	$1,000

New HDHP and HSA Rules for 2026

Under the OBBBA, several important changes expand HSA eligibility and flexibility:

1. Expanded HDHP Qualification

• Bronze and catastrophic ACA plans now qualify as HDHPs for HSA purposes
• This significantly expands the population eligible to contribute to HSAs

2. Permanent First-Dollar Telehealth Coverage

• HDHPs can now offer first-dollar telehealth coverage without affecting HSA eligibility
• Previously temporary during COVID-19, now permanent
• Employees can access virtual care without meeting their deductible

3. Direct Primary Care (DPC) Payments

• Direct primary care membership fees now count as qualified medical expenses
• Employees can use HSA funds to pay for DPC arrangements

HSA vs. FSA: Understanding the Differences

Feature	Medical FSA	Health Savings Account (HSA)
2026 Contribution Limit	$3,400	$4,400 (self) / $8,750 (family)
Employer Contributions	Optional	Allowed and common
Funds Availability	Entire amount available day 1	Only contributed amounts available
Fund Rollover	Limited ($640 or grace period)	Unlimited — fully rolls over
Portability	No (lose if leave employer)	Yes (employee-owned account)
Requires HDHP	No	Yes — must have qualifying HDHP
Investment Options	No	Yes — can invest like a 401(k)
Triple Tax Advantage	Single (pre-tax contributions)	Pre-tax contributions, tax-free growth, tax-free withdrawals

HSA Best Practices for Employers

1. Offer Employer Contributions

• Seed accounts with employer contributions ($500-$1,000 common)
• Increases employee participation and satisfaction
• Further reduces employer payroll taxes

2. Educate on Long-Term Savings

• Position HSAs as retirement savings vehicles, not just expense accounts
• Highlight investment options for employees who don’t need immediate funds
• Show compound growth potential over 20-30 years

3. Ensure HDHP Compliance

• Verify your health plan meets minimum deductible requirements
• Confirm out-of-pocket maximums don’t exceed IRS limits
• Update plan documents to reflect new telehealth and DPC provisions

Commuter Benefits (Transit and Parking FSAs)

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

2026 Commuter Benefit Limits

• Transit FSA: $340 per month
• Parking FSA: $340 per month

Eligible Expenses Include:

• Public transit passes (bus, subway, train, ferry)
• Vanpooling services
• Parking fees at or near the workplace
• Parking at transit stations for commuting purposes

Not Eligible:

• Tolls and mileage
• Parking at home
• Uber, Lyft, or taxi services

Commuter Benefits Advantages

For Employees:

• Save up to $1,000+ annually in taxes on commuting costs
• Convenient payroll deduction
• Can adjust contributions monthly (more flexible than FSAs)

For Employers:

• Attract employees in urban markets where commuting is expensive
• Reduce employer FICA taxes
• Environmentally friendly benefit that supports sustainability goals

Implementation Note: Commuter benefits typically require a third-party administrator or commuter benefit card provider to manage transit passes and parking validations.

Advantages of Section 125 Plans

Benefits for Employees

Tax Savings:

• Reduce federal income tax, FICA, and state income tax
• Save 25-35% on eligible expenses depending on tax bracket
• Increase take-home pay without reducing benefits

Financial Flexibility:

• Budget for predictable healthcare and dependent care expenses
• Access pre-tax funds for regular expenses throughout the year
• Choose benefits that match individual needs

Example Employee Savings:

An employee in the 24% federal tax bracket contributes:

• Medical FSA: $3,400
• Dependent Care FSA: $7,500 (2026)
• Total contributions: $10,900
• Total tax savings: ~$3,540/year (including FICA)

Benefits for Employers

Payroll Tax Savings:

• Reduce FICA obligations (7.65% on employee contributions)
• Lower FUTA taxes
• State payroll tax reductions where applicable

Example Employer Savings:

100 employees averaging $5,000 in Section 125 contributions:

• Total employee contributions: $500,000
• Employer FICA savings: ~$38,250/year

Recruitment and Retention:

• Competitive benefits package attracts quality candidates
• Increases employee satisfaction and loyalty
• Modern benefits appeal to younger workforce

Cost-Effective Benefits:

• Provide valuable benefits without large direct employer contributions
• Many benefits are 100% employee-funded
• Administrative costs are typically low ($3-10 per employee per month)

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Compliance Requirements for Section 125 Plans

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

1. Written Plan Document (Required)

Employers must create and maintain a formal written plan document that includes:

• Plan name and effective date
• Employer and employee eligibility requirements
• Benefits offered and contribution limits
• Election procedures and deadlines
• Permitted qualifying life events
• Claims and reimbursement procedures
• Nondiscrimination testing methodology
• Plan amendment and termination provisions

Penalty for Non-Compliance: Without a written plan document, the IRS may disqualify the plan, resulting in taxable income for employees and loss of payroll tax savings.

2. Nondiscrimination Testing (Annual Requirement)

Section 125 plans cannot disproportionately favor highly compensated employees (HCEs) or key employees. Employers must conduct annual testing:

Three Required Tests:

a) Eligibility Test

• Ensures a reasonable percentage of non-highly compensated employees (NHCEs) are eligible
• Generally passes if plan is available to all employees or a broad classification

b) Benefits and Contributions Test

• Verifies that benefits and employer contributions are provided on a fair and consistent basis
• Actual contributions by HCEs cannot exceed 125% of the average contributions by NHCEs

c) Key Employee Concentration Test

• Ensures key employees (owners, officers, highly paid employees) don’t receive more than 25% of total tax-free benefits
• Applies to employers with key employees

Testing Timeline:

• Must be completed by end of plan year (December 31 for calendar-year plans)
• If tests fail, corrective actions required within 2.5 months after plan year end
• May require additional taxable income reported to HCEs or refunds

3. Annual Enrollment Period

Employees can only make benefit elections or changes during:

Annual Open Enrollment

• Typically 2-4 weeks before the plan year begins
• Employees select benefits and contribution amounts for the upcoming year
• Elections are irrevocable once the plan year starts (except for qualifying events)

Qualifying Life Events (Mid-Year Changes)

Section 125 permits mid-year election changes only for qualifying life events:

• Marriage or divorce
• Birth or adoption of a child
• Death of spouse or dependent
• Change in employment status (spouse or employee)
• Dependent gains or loses eligibility
• Significant change in health coverage costs
• FMLA leave

Important: Changes must be consistent with the life event. For example, an employee cannot increase Dependent Care FSA contributions due to marriage alone—they’d need to demonstrate increased dependent care costs.

4. COBRA Compliance

Health FSAs are subject to COBRA continuation coverage requirements if:

• Employer has 20 or more employees
• Employee has a positive balance at the time of qualifying event (termination, reduction in hours)

COBRA for FSAs:

• Employees can elect to continue their Health FSA coverage
• Must pay 102% of the monthly cost
• Rarely elected since employees must pay more than their remaining balance
• Employers must offer but tracking is administratively burdensome

5. ERISA Compliance (If Applicable)

If a Section 125 plan involves employer contributions to FSAs or includes more than just a POP, it may be subject to ERISA (Employee Retirement Income Security Act) requirements:

• Summary Plan Description (SPD) distributed to participants
• Form 5500 annual reporting (if plan covers 100+ participants)
• Claims and appeals procedures
• Fiduciary responsibilities

Exception: Premium-only plans (POPs) are generally exempt from ERISA requirements.

6. IRS and Tax Reporting

Form W-2 Reporting:

• Dependent Care FSA contributions must be reported in Box 10
• Other FSA contributions reduce Box 1 (wages) but don’t need separate reporting

Form 2119 (Dependent Care Providers):

• Employees must provide provider Tax ID numbers when claiming Dependent Care FSA reimbursements
• Employers should collect this information during the claims process

How to Set Up a Section 125 Plan

Step 1: Determine Which Benefits to Offer

Assess your workforce needs and budget to decide which Section 125 components to include:

Starter Plan (Minimal Compliance):

• Premium-Only Plan (POP) for pre-tax insurance premiums

Standard Plan (Most Common):

• POP
• Medical FSA
• Dependent Care FSA

Comprehensive Plan (Competitive):

• POP
• Medical FSA ($3,400 limit)
• Dependent Care FSA ($7,500 limit)
• HSA (if offering HDHP)
• Commuter benefits

Decision Factors:

• Employee demographics (parents, commuters, ages)
• Current health plan design (HDHP vs. traditional)
• Administrative capacity and budget
• Competitive landscape in your industry

Step 2: Draft a Written Plan Document

A formal plan document is legally required and must include all IRS-mandated provisions.

Options for Creating Plan Documents:

Option 1: Third-Party Administrator (TPA)

• Most TPAs provide template plan documents as part of their service
• Documents are pre-approved and regularly updated for compliance
• Least risky option for employers

Option 2: Payroll Provider

• Many payroll companies (ADP, Paychex, Gusto) offer Section 125 administration
• Integrated with existing HR/payroll systems
• Plan documents often included

Option 3: ERISA Attorney

• Custom plan documents drafted specifically for your organization
• Most expensive option ($3,000-$10,000+)
• Recommended for complex plans or large employers

Best Practice: For most small to mid-sized businesses, partnering with a TPA or payroll provider offers the best balance of compliance, cost, and convenience.

Step 3: Choose an FSA or Benefits Administrator

Most companies partner with third-party administrators (TPAs) to handle:

TPA Responsibilities:

• Plan document creation and updates
• Enrollment platform and employee portal
• Claims processing and reimbursements
• Debit card issuance and management
• Compliance monitoring and nondiscrimination testing
• IRS reporting and documentation
• Employee support and education

Popular Section 125 / FSA Administrators:

• WageWorks (Health Equity)
• Payflex
• TASC (Total Administrative Services Corporation)
• Benefit Resource
• Discovery Benefits
• FSA Store
• Your payroll provider (ADP, Paychex, Gusto often include FSA administration)

TPA Cost Structure:

• Setup fees: $500-$2,000
• Monthly administration: $3-$10 per participating employee
• PEPM (per employee per month) or flat annual fee models

Step 4: Configure HR/Payroll Systems

Work with your HR/payroll provider to:

Set Up Deduction Codes:

• Medical FSA (pre-tax)
• Dependent Care FSA (pre-tax)
• HSA employee contributions (pre-tax)
• HSA employer contributions
• Commuter transit (pre-tax)
• Commuter parking (pre-tax)

Configure Tax Treatment:

• Ensure deductions reduce Box 1 wages (federal taxable income)
• Reduce FICA taxable wages
• Properly report Dependent Care FSA in Box 10 of W-2

Test Payroll Integration:

• Run test payroll before open enrollment
• Verify deductions appear correctly on pay stubs
• Confirm proper tax withholding calculations

Step 5: Conduct Employee Enrollment

Education is critical for successful Section 125 plan adoption.

Pre-Enrollment (4-6 Weeks Before):

• Announce new benefits or changes
• Provide overview of Section 125 plans and tax savings
• Share contribution limits and eligible expenses
• Explain use-it-or-lose-it rules and planning strategies

During Enrollment (2-4 Weeks):

• Offer group webinars or lunch-and-learns
• Provide one-on-one benefits counseling
• Share planning tools and calculators
• Distribute enrollment guides and FAQs
• Set clear deadlines and communicate frequently

Post-Enrollment:

• Confirm elections with employees
• Provide welcome packets with account details
• Issue FSA debit cards
• Share expense tracking tools and mobile apps

Key Communication Topics:

Medical FSA Education:

• How much to contribute based on anticipated expenses
• Eligible vs. ineligible expenses
• How to submit claims and use debit cards
• Carryover rules and grace period
• Planning to avoid forfeiture

Dependent Care FSA Education:

• Contribution limits and tax credit comparison
• Eligible providers and required documentation
• Contribution pacing (funds available as contributed)
• Coordination with tax-filing strategies

New for 2026: Heavily promote the increased $7,500 Dependent Care FSA limit to working parents—this represents significant new tax savings opportunities.

Step 6: Perform Nondiscrimination Testing

Employers must conduct annual nondiscrimination testing to ensure the plan doesn’t favor highly compensated employees.

Testing Schedule:

• Complete testing by end of plan year
• Document results and retain for IRS audits
• If tests fail, implement corrections within 2.5 months

Who Conducts Testing:

• Usually handled by your TPA or benefits administrator
• Some payroll providers include testing in their service
• Can be performed by ERISA attorney or benefits consultant
• Larger employers may have internal compliance staff

Test Failure Remedies:

If your plan fails nondiscrimination testing:

Option 1: Refund Excess Contributions

• Return excess contributions to HCEs
• HCEs must pay taxes on refunded amounts
• Administrative burden and employee dissatisfaction

Option 2: Employer Contribution to NHCEs

• Make additional employer contributions to NHCE accounts
• Improves testing results for following year
• Can be expensive depending on workforce size

Option 3: Plan Design Changes

• Modify eligibility or contribution structures for next year
• May include auto-enrollment or employer seed contributions

Prevention Strategies:

• Offer benefits broadly to all employees with minimal waiting periods
• Provide employer contributions or matching to increase NHCE participation
• Actively promote benefits to ensure balanced participation
• Monitor participation rates throughout the year

Common Mistakes to Avoid

1. Not Having a Formal Written Plan Document

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

The Consequence:

• Plan disqualification by IRS
• Loss of tax benefits for all employees
• Potential penalties and back taxes
• Personal liability for plan administrators

The Solution: Work with a TPA, payroll provider, or ERISA attorney to create compliant plan documents before offering any Section 125 benefits.

2. Failing Nondiscrimination Testing

The Problem: Plans that disproportionately favor executives or highly compensated employees fail IRS testing requirements.

The Consequence:

• Benefits become taxable income for HCEs
• Employee dissatisfaction and confusion
• Administrative burden of corrective distributions
• Potential IRS penalties

The Solution:

• Conduct testing annually with your TPA
• Monitor participation rates throughout the year
• Adjust plan design to encourage broader participation
• Consider employer contributions to boost NHCE enrollment

3. Poor Employee Communication and Education

The Problem: Many employees underfund FSAs, forfeit unused balances, or don’t understand how to use their benefits effectively.

The Consequence:

• Low participation rates
• Employee frustration with forfeited funds
• Reduced value perception of benefits package
• Higher administrative costs per participant

The Solution:

Before Enrollment:

• Conduct benefits fairs and education sessions
• Provide contribution planning calculators
• Share real-world examples and scenarios
• Explain eligible expenses clearly

During Plan Year:

• Send quarterly balance reminders
• Highlight upcoming expense deadlines
• Share creative ways to use FSA funds
• Promote carryover or grace period options

Before Year-End:

• Send multiple reminders about deadlines
• Suggest last-minute eligible purchases
• Explain how to submit claims
• Promote FSA Store or other eligible expense retailers

4. Mismanagement of Mid-Year Election Changes

The Problem: Section 125 plans have strict rules about when employees can modify their elections. Allowing changes outside of qualifying life events violates IRS regulations.

The Consequence:

• Plan disqualification risk
• Incorrect tax withholding
• Compliance violations
• Administrative headaches during audits

The Solution:

• Clearly document all qualifying life events in plan documents
• Require proof of qualifying events (birth certificates, marriage licenses, etc.)
• Train HR staff on permissible mid-year changes
• Implement election change request forms with attestation
• Work with TPA to ensure proper documentation

Valid Qualifying Life Events:

• Marriage, divorce, legal separation, annulment
• Birth, adoption, or placement for adoption
• Death of spouse or dependent
• Change in employment status (for employee or spouse)
• Dependent satisfies or ceases to satisfy eligibility
• Change in residence
• COBRA, Medicare, Medicaid eligibility changes
• Court-ordered coverage changes

Election Change Must Be Consistent: The IRS requires that mid-year election changes be “consistent” with the qualifying event. For example:

• ✅ Birth of child → Increase Dependent Care FSA
• ✅ Divorce → Decrease Medical FSA (no longer covering spouse)
• ❌ Marriage → Decrease Dependent Care FSA (inconsistent without justification)

5. Not Offering Carryover or Grace Period Options

The Problem: Without carryover or grace period options, employees forfeit unused Medical FSA funds at year-end, leading to frustration and reduced participation.

The Consequence:

• Decreased employee satisfaction
• Lower FSA participation in subsequent years
• Perception that FSAs are “risky” benefits
• Competitive disadvantage vs. employers offering flexibility

The Solution:

• Implement the $640 carryover provision for Medical FSAs (2024 limit, expected to increase)
• OR offer a 2.5-month grace period (but not both)
• Clearly communicate carryover rules during enrollment
• Send year-end reminders about carryover amounts

Best Practice: Most employers prefer the carryover option because:

• Employees find it easier to understand
• No confusing dual plan-year expense periods
• Reduces year-end rush to spend funds
• Increases overall FSA satisfaction

Note: Dependent Care FSAs cannot offer carryover—only the grace period option is available per IRS regulations.

6. Inadequate Recordkeeping and Documentation

The Problem: Failing to maintain proper records of plan documents, elections, life events, nondiscrimination testing, and communications.

The Consequence:

• Inability to defend plan during IRS audit
• Compliance violations and penalties
• Difficulty resolving employee disputes
• Loss of institutional knowledge during staff transitions

The Solution:

• Maintain organized files of all plan documents and amendments
• Retain all employee election forms (electronic or paper)
• Document qualifying life event approvals with supporting evidence
• Keep nondiscrimination testing results for at least 6 years
• Archive employee communications and enrollment materials
• Use your TPA’s document management system if available

Recommended Retention Periods:

• Plan documents: Permanent
• Employee elections: 6 years after plan year end
• Nondiscrimination testing: 6 years
• Claims documentation: 6 years
• Communications: 3 years

7. Not Updating Plan Documents for Legal Changes

The Problem: Section 125 regulations change regularly. The 2026 OBBBA changes are a perfect example—employers must update plan documents to reflect new limits and benefits.

The Consequence:

• Operating under outdated plan terms
• Compliance violations
• Incorrect contribution limits
• Failed audits

The Solution:

• Review plan documents annually with your TPA or attorney
• Update by December 31 before new plan year (for calendar-year plans)
• Distribute Summary of Material Modifications (SMMs) to employees
• Train HR staff on changes before open enrollment

2026 Required Updates:

• New Medical FSA limit: $3,400
• New Dependent Care FSA limit: $7,500
• New HSA limits: $4,400 / $8,750
• New commuter limits: $340/month
• Updated HDHP definitions (bronze plans, telehealth, DPC)

8. Overlooking State-Specific Requirements

The Problem: Some states have additional rules or tax treatments for Section 125 plans that differ from federal regulations.

The Consequence:

• State compliance violations
• Incorrect state tax withholding
• Penalties and fines from state agencies

The Solution:

• Consult with benefits attorney familiar with your state(s)
• Work with payroll provider to ensure correct state tax treatment
• Review state-specific requirements for:
  • Paid family leave coordination
  • State disability insurance (SDI) implications
  • Local commuter benefit mandates (e.g., San Francisco, NYC)
  • State income tax treatment of FSAs

States with Special Considerations:

• California: State Disability Insurance (SDI) may not be reduced by Section 125 elections
• New Jersey: Similar SDI considerations
• New York City, San Francisco, Seattle: Mandatory commuter benefit requirements
• Massachusetts: Paid family leave coordination with Dependent Care FSAs

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Final Thoughts: Is a Section 125 Plan Right for Your Business?

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 flexible approaches to healthcare, dependent care, and other essential expenses.

When Section 125 Plans Make Sense

Ideal for businesses that:

• Have 10+ employees (administrative costs justified by tax savings)
• Offer employer-sponsored health insurance
• Have employees with predictable healthcare or dependent care costs
• Want to improve recruitment and retention
• Seek to reduce payroll tax obligations
• Compete for talent in competitive markets

Especially valuable for:

• Companies with many working parents (Dependent Care FSAs)
• Organizations with commuter employees in urban areas
• Businesses offering high-deductible health plans (HSAs)
• Employers looking for cost-effective benefits enhancements

When to Reconsider

Section 125 plans may not be ideal if:

• You have very few employees (under 10)
• High turnover makes administration difficult
• Employees lack understanding of benefits
• Limited HR capacity to manage compliance
• Risk of failing nondiscrimination testing is high

However, even small businesses can benefit from a simple Premium-Only Plan (POP) with minimal administrative burden.

2026: A Strategic Opportunity

The OBBBA changes for 2026 present a unique opportunity to:

• Enhance your benefits package with minimal additional employer cost—most Section 125 benefits are employee-funded.
• Attract and retain working parents with the dramatically increased $7,500 Dependent Care FSA limit.
• Differentiate your organization by offering expanded HSA options and flexible benefit choices.
• Demonstrate commitment to employee financial wellness through tax-advantaged savings opportunities.
• Reduce organizational tax burden through lower FICA and payroll taxes.

Next Steps for Implementing a Section 125 Plan

For Businesses New to Section 125 Plans

✅ Month 1-2: Planning and Assessment

• Assess workforce demographics and benefits needs
• Research TPAs and benefits administrators
• Obtain quotes for administration services
• Decide which Section 125 components to offer

✅ Month 2-3: Documentation and Setup

• Select TPA or benefits administrator
• Draft and adopt written plan documents
• Configure HR/payroll system integrations
• Develop employee communication materials

✅ Month 3-4: Enrollment and Launch

• Conduct employee education sessions
• Open enrollment period (2-4 weeks)
• Process elections and setup accounts
• Issue FSA debit cards

✅ Ongoing: Administration and Compliance

• Process claims and reimbursements
• Monitor participation rates
• Conduct annual nondiscrimination testing
• Update plan documents for regulatory changes

For Businesses with Existing Section 125 Plans

✅ Q4 2025: Prepare for 2026 Changes

• Review and amend plan documents for new limits
• Update HR/payroll systems for new contribution caps
• Prepare employee communications highlighting changes
• Plan for increased Dependent Care FSA participation

✅ November 2025: Employee Communications

• Announce 2026 benefit changes
• Emphasize increased Dependent Care FSA limit ($7,500)
• Explain new HSA flexibility (bronze plans, telehealth, DPC)
• Distribute updated Summary Plan Descriptions

✅ December 2025: Open Enrollment

• Conduct enrollment with new 2026 limits
• Collect employee elections
• Ensure compliance with updated contribution caps
• Complete nondiscrimination testing

✅ January 1, 2026: Implementation

• New contribution limits take effect
• Begin processing claims under updated rules
• Monitor for any issues or questions

Resources and Professional Support

Finding the Right Partners

Third-Party Administrators (TPAs): Research and compare FSA administrators based on:

• Cost structure and fees
• Technology platform and mobile app quality
• Customer service and employee support
• Claims processing speed
• Compliance and testing services
• Integration with your payroll system

Request demos and references from at least 3 TPAs before selecting.

ERISA Attorneys and Benefits Consultants: Consider hiring specialized legal counsel if:

• You’re a large employer (500+ employees)
• Your plan is complex with multiple components
• You’ve failed nondiscrimination testing
• You’re facing an IRS audit
• You have unique workforce situations

Payroll Providers: Many payroll companies now offer integrated Section 125 administration:

• ADP
• Paychex
• Gusto
• Justworks
• TriNet

Advantages: Seamless integration, single vendor relationship, often cost-effective for small businesses.

Educational Resources

IRS Publications:

• IRS Publication 15-B (Employer’s Tax Guide to Fringe Benefits)
• IRS Publication 969 (Health Savings Accounts and Other Tax-Favored Health Plans)
• IRS Notice 2024-XX (OBBBA implementation guidance—forthcoming)

Professional Organizations:

• International Foundation of Employee Benefit Plans (IFEBP)
• American Benefits Council