What is a Section 125 Plan, Anyway? And How Does It Affect Our Payroll?
Clients frequently contact us to report that they are implementing a new benefit plan that will require voluntary deductions from employee paychecks as part of their payroll processing services. When something like this comes up, we ask clients should this deduction be pre-tax or post-tax? Almost invariably, they advise that it should be a pre-tax deduction when that may not always be the case. Situations like this remind us that there are common misperceptions about when it is appropriate to deduct wages from employee pay on a pre-tax basis. So we thought we would take a minute to clear some things up, and specifically to answer the age old question…”What is a Section 125 plan, anyway?”
In order to allow your employees to pay health insurance premiums on a pre-tax basis, you need to have what is referred to as a Section 125 Plan, in place. Section 125 is the section of the IRS tax code where the items that can be deducted from employee pay on a pre-tax basis are defined. In the context of Section 125, “pre-tax” means that a deduction is exempt from Federal Income Tax Withholding, Social Security and Medicare Taxes. The employer also saves, because a Section 125 deduction also reduces the employer’s portion of the Social Security and Medicare tax liability.
The Section 125 Plan is just a document that describes the specific ways in which the employer is allowing employees to take advantage of these pre-tax deduction options. A Section 125 Plan is something that the employer must maintain separately from the health insurance policy or any other benefit program that their employees participate in, and the Section 125 Plan includes a Summary Plan Description, which should be updated annually.
Who Provides Section 125 Plan Administration?
Often, the Section 125 plan itself and the Summary Plan Description are provided by a third party administrator, for an annual fee. Depending on the complexity of the Section 125 Plan, there may also be a per employee, per month fee for this administration work. A per participant fee is most commonly charged when the Section 125 Plan includes the ability for employees to deposit pre-tax money into a Flexible Spending Account (FSA). In this case, the plan administration includes more than just an annual update to the Section 125 plan document. The third party administrator for a plan that includes FSA is also responsible for handling the processing of receipts that employees submit for legitimate FSA expenses like child care expenses.
A Premium Only Plan (POP) is the simplest type of Section 125 Plan. It is the easiest type of Section 125 Plan to maintain and it involves little or no annual discrimination testing. A POP plan is used when health insurance, dental insurance and/or vision insurance are the only benefits that the employees will be paying for on a pre-tax basis.
Much like 401k, the maintenance of a Section 125 Plan is required to ensure compliance with the IRS tax code. Often, Section 125 Plan Administration can be taken care of for you by the employee benefits specialist who you purchased the health insurance policy (or other benefits program) from. Some payroll companies also offer solutions for this. At Checkmate, we work with a third party administrator to provide these services to our clients at a discounted rate.
What are Qualified Benefits Under Section 125?
Some examples of benefits that qualify as part of a Section 125/Cafeteria Plan and thus the pre-tax exemption from an employee’s gross pay include:
- Accident and health benefits (but not Archer medical savings accounts or long-term care insurance)
- Adoption assistance
- Dependent care assistance
- Group-term life insurance coverage
- Health savings accounts, including distributions to pay long-term care services
As part of outlining the benefits available, employers should ensure their Section 125 plans specifically spell out rules for eligibility and employee elections. It is also important to have the proper systems in place to maintain strict adherence to the rules like Checkmate’s Workforce Ready HRIS Software, which ties the employee self-service aspect of our payroll services in with automated benefits administration alerting HR, management and employees when they become eligible and providing the ability for employees to make their benefits elections electronically or opt-out.
Thinking about implementing a Section 125 plan and wondering how to properly manage and administer the pre-tax deductions for your employees?