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Section 125 Plan AKA the Cafeteria Plan – How it Benefits Both Employers and Employees

27 August 2019 No Comment

Income taxes, everyone needs to pay them and almost everyone agrees that we pay way too much. Depending on what you earn, you can pay as much as 30 percent of your net income in income taxes. 

However, if you are smart you can legally save a significant amount of money that would otherwise go into paying income tax. The cafeteria plan also referred to as the section 125 plan allows employees to save a portion of their income from being tax deductible. It works by reducing your taxable income by giving you the option to invest in benefits before your income is calculated.

What is the Section 125 Plan?

The section 125 plan is under the IRS Code. Under this plan, employees are allowed to select and pay for certain qualified benefits before their taxable income is calculated. In other words, it’s a plan that allows employees to pay for benefits they usually pay for with their post-tax money.

What is the benefit of doing that? By deducting the cost of these benefits before the tax is calculated, employees reduce their taxable income. Considering income tax percentages apply to taxable income, they are able to save money.

How Much Money Can an Employee Save with the 125 Plan?

How much money employees save depend on their salaries and the benefits they opt for under the section 125 plan

For the sake of an example, let’s consider an individual with a salary of $2,000 per month or $24,000 per year. Let’s also assume that the person opted for paying for health insurance and monthly medical expenses under the section 125 plan. Be warned, we are oversimplifying things as there are other taxes and details we are overlooking for keeping the calculation easy to understand.

Without Section $125

A person earning $24,000 per year needs to pay 12% income tax or $2,880.

So his or her post-tax income is $21,120.

Let’s consider the person spends $50 per month  buying medicine or paying for medical expenses. Let’s also consider that the individual pays $100 per month on health insurance premiums. So, that’s a yearly cost of $600 on medical expenses plus $1,200 on health insurance and a total expense of $1,800 per year.

So the money left after paying medical expenses and health insurance is ($21,120 – $1,800) $19,320.

With Section 125 Plan

When the same person opts for the section 125 plan, the cost of the medical expenses and health insurance are deducted to determine the taxable income. 

Therefore, the total taxable income the same person would reduce to ($24,000 – $1,800) $22,200.

The 12% income tax will be calculated on $22,200. That’s $2,664 paid in income tax per year. Therefore, the net income after taxes under the section 125 plan comes to $19,536

Compare that to the $19,320 net income without the section 125 plan and the person saves $216 per year.

The person will actually save a lot more as we didn’t calculate social security tax, which is calculated on the taxable income.

Long story short, the Section 125 reduces your taxable income by allowing you to buy benefits you would need to spend on anyways.

How it Benefits Employers?

Employers are also incentivized by the IRS for participating in the cafeteria plan. For every employee they enroll in the plan, they save on federal and state taxes. Depending on how many employees in their organization opts for the 125 plan, they can save on FICA, FUTA, and SUTA taxes.  

Employers also save money by paying less premium for workers’ compensation insurance. 

What Kind of Benefits Can the Section 125 Plan Include?

The section 125 plan is mainly geared towards medical benefits.  The plan can include benefits to cover the cost of over-the-counter and prescription medication. It may also cover the expenses of on-going treatments. Everything from routine eye exams and dental procedures to acupuncture treatment can be covered under the plan.

The plan commonly includes a corporate group health policy that covers the cost of medical expenses and hospitalization costs. In a lot of cases, these plans include more benefits than the employer’s individual plan at a lower premium

The Easiest Way for Companies to Manage the Cafeteria Plan

Benefits administration can be a complicated subject and requires the employment of qualified individuals who have the knowledge to keep your firm compliant. 

Educating employees about the section 125 plan and encouraging them to participate can also prove to be a hurdle.

This is why the easiest way to administer and start a cafeteria plan is by hiring a reliable employee benefits company. 


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