A §125 plan, also known as a cafeteria plan, allows employees to choose between receiving taxable cash compensation or qualified pre-tax benefits. By paying for benefits with pre-tax dollars, employees lower their taxable income while employers reduce payroll tax liability.
Key requirements
To qualify as a §125 plan, the arrangement must:
Be in writing.
Allow employees to choose between at least two options (cash or qualified benefits).
Include only employees as participants (independent contractors and owners generally cannot participate).
Qualified benefits under §125
Examples of benefits that may be offered under a cafeteria plan include:
Medical, dental, and vision insurance
Group-term life insurance (up to IRS limits)
Dependent care assistance (up to $5,000 annually)
Disability coverage (short- or long-term)
Flexible spending accounts (FSAs)
401(k) contributions (FICA taxable)
Cash in lieu of benefits (taxable)
Restrictions
Benefits must be used during the plan year; unused funds may be forfeited unless a rollover or grace period applies.
Reimbursements cannot be issued in advance.
Employees must authorize all deductions in writing.
Deferrals are not allowed, except for 401(k) contributions.
Tax treatment
Contributions under a §125 plan:
Reduce federal income tax, Social Security (FICA), and FUTA taxable wages.
May or may not reduce state or local taxable wages, depending on jurisdiction.
Must be deducted from employee compensation (wages, bonuses, PTO payouts) to qualify as pre-tax.
Reporting highlights
Benefit Type | Reporting Requirement |
Dependent care FSA | Up to $5,000 in Box 10 of Form W-2 |
Excess dependent care contributions | Include in W-2 Boxes 1, 3, and 5 |
Group-term life (over IRS limits) | W-2 Box 12, Code C |
401(k) deferrals | W-2 Box 12, Code D |
Cash in lieu of benefits | Add to W-2 Box 1 wages |
Need help?
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