A Section 125-sometimes called a Cafeteria Plan-is a federal tax code provision that allows companies to deduct certain qualified expenses from an employee's paycheck on a pre-tax basis. These expenses include health insurance premiums, dental insurance premiums, 401(k) contributions, certain medical expenses and even dependant day care costs.

Employee Upside

When benefits are deducted from an employee's salary before you deduct state and local taxes, it reduces the actual cost of the benefit and increases the employee's take-home pay. Their take-home pay increases because you have effectively reduced their taxable income, so they pay less tax to Uncle Sam. And the employee will have paid for the benefit with "pre-tax dollars," so the out-of-pocket cost of the benefit is reduced. This means that the benefit will be 20 to 40 percent cheaper (depending on the employee's tax bracket) than if they had paid for the benefit with "after-tax dollars."

For Example:
Sally Sue's salary is $64,000, and she contributes $4,500 annually towards her insurance.

After-tax Example

$64,000 gross income
-$16,000 taxes (25%)
$48,000 adjusted gross income
-$4,500 insurance cost(deducted after tax)
$43,500 take-home pay

Pre-tax Example

$64,000 gross income
-$4,500 insurance cost (deducted pre-tax)
$59,500 adjusted gross income
-$14,875 taxes (25%)
$44,625 take-home pay

By deducting Sally's insurance premiums pre-tax, you have increased her take-home pay by $1,125 annually!

Employer Upside

Sally's savings are only the tip of the iceberg. The company will also experience a financial upside. As your employee's taxable income is reduced, so is the amount of FICA the company pays in matching payroll taxes. By reducing your employee's taxable income you also reduce your payroll tax burden. For every dollar your employees move to a pre-tax status, you save 7.65 percent in FICA payroll taxes. That means if you have a company of 10 Sally Sue's who contribute a combined $45,000 toward their health insurance, you will save $3,442 annually. If you have 50 employees who contribute this amount, you would save $17,212.

Establishing a Section 125

To take advantageous of the Section 125 tax benefits, your company will need to set up a Cafeteria Plan. The cafeteria plan allows your employees to choose which benefits they want to have deducted pre-tax. Most health insurance companies will complete the necessary paperwork for you and administer your plan for free. Once the plan is established, you will receive a Plan Document that outlines the details of the plan, including who is eligible and what is covered.

How does it Work

When setting up your plan you will choose the categories of employees who are eligible to participate such as full-time employees, or employees working over 30 hours per week. You will also establish your "plan year." The plan year dictates when changes can be made to the plan, and when employees can add or delete coverage.

All changes to a pre-tax deduction must be made during open enrollment, which is one month prior to the beginning of your next plan year. There are a few exceptions that relate to major life changes such as marriage, divorce, death or the birth of a child. Allowing employees to make changes mid plan year, without evidence of a life status change, can result in the IRS pulling the company's Section 125 eligibility.

Once your plan is in place, simply give your payroll service or accounting department a deduction report that shows which expenses will be deducted from each employee's paycheck pre-tax.

Who is Eligible to Participate?

Some business owners will not be able to personally participate in the Cafeteria Plan. Although employees of most business types are eligible, sole proprietors, partners, and individuals who own more than a 2 percent share of an S Corporation are not eligible to participate. Ask your tax advisor for guidance if you are unsure of your eligibility.