Section 125 FAQs

A: With a Section 125 plan in place allowing employees to have pre-tax deductions to pay for their share of benefit costs, tax savings for employees and the employer are significant:

• Participant tax savings: Any employee payroll deductions for eligible benefits are exempt from federal income tax, state income tax, and the employee’s share of FICA/Social Security taxes (7.65%).
• Employer tax savings: Any employee payroll deductions are exempt from the employer’s FICA/Social Security match (7.65%).

A: If an employer sponsors a Section 125 plan, common-law employees may generally participate and utilize pre-tax deductions for benefits if they meet eligibility requirements set by the employer. Any eligible employee may also pay on a pre-tax basis for premiums or contributions toward coverage a legal spouse or qualifying dependent(s).

IRS rules do not allow non-employees to utilize tax-free benefits. Individuals who are contractors and receive 1099 income rather than W-2 income are not eligible. Similarly, an employee may not use pre-tax deductions to cover an individual who is not a legal spouse or qualifying dependent. Any coverage for a domestic partner is taxable.

Owners and family members of owners can only participate in limited circumstances. If the organization is a C-Corporation, owners are eligible to utilize tax-free benefits. However, if the organization is an S-Corp, LLC, Partnership, or Sole Proprietorship, an owner or family member cannot participate in Section 125. The reasoning behind this IRS rule is that since these entities are “pass-through” for purposes of income and deductions, the owners will receive applicable tax deductions on their personal returns already without the need to receive them as employees and as owners.

A: A unique rule under Section 125 is that once an election is made at the start of a plan year (or new period of coverage for a new hire or individual gaining eligibility mid-year), the election is locked in and cannot be changed for the remainder of the plan year. A plan year is generally 12 months and coincides with the employer’s renewal of insurance benefits and annual open enrollment.

An exception to the annual election rule is if an employee experiences a mid-year Qualifying Event or HIPAA Special Enrollment event that is recognized by the rules as the basis for an election change. For a mid-year change to be allowed by the plan, two requirements must be met. First, the facts giving rise to the requested change must represent a formal Qualifying Event or HIPAA Special Enrollment opportunity. Second, the requested change must be consistent with the event (the “Consistency Rule”). If the change is allowable under the rules, the employee may make a change to the pre-tax election for benefits that applies from the point of the change forward through the remainder of the plan year.

NOTE: The election rule only applies to pre-tax elections under Section 125. If an employee is enrolled in any benefit for which a pre-tax election is not applicable - such as if a benefit is fully employer paid or is paid with a post-tax election such as a supplemental life benefit or disability coverage - an election change can be made without a Qualifying Event.

A: Since 125 plans involve significant tax savings to employees and employers, IRS rules include certain guidelines to ensure that benefits are available to employees on a non-discriminatory basis. Below is a summary of tests that may apply. Certain 125 plans are exempt from testing. These include plans that do not have any Highly Compensated Employees or Key Employees, or plans that meet the provisions of the “Simple Cafeteria Plan” guidance from the IRS. (In this context, “Simple” is not directly related to the name of this service.) Additional information is available on testing and testing exemptions.

If testing applies, there are three different non-discrimination analyses for Section 125 plans which include only pre-tax premiums and contributions but not Flexible Spending Accounts. Note: Unlike the formal testing done for retirement plans, what is required under Section 125 is not that the employer run these tests and submit the tests to an authoritative body. Instead, the rules are in place as guidelines so that if an employer’s plan were ever scrutinized/tested by the IRS, the plan would pass. No formal testing or reporting of testing to the IRS is required.

The first two tests address (1) eligibility to participate, and (2) contribution/benefits. Both categories can be handled by plan design. If an employer applies its eligibility standards and contributions equally to all full-time employees, then the plan will automatically pass those tests.

There is a third test that is based on plan utilization - specifically, measuring the amount of pre-tax benefits used by certain Key Employees relative to those elected by non-Key Employees. This is the Key Employee Concentration Test, commonly known as the “25% Test.” This test is not an issue for most plans but may be a factor for plans sponsored by small employers with a heavy concentration of pre-tax elections by owners, officers, and highly compensated individuals.

To confirm, even if testing is applicable to a particular plan, testing or analysis is not included in the Simple 125 service. Simple 125 is designed only to assist employers with the plan document requirement.

A: Having a formal Plan Document and SPD in place is the primary compliance requirement for Section 125 plans. Other rules and considerations apply, as referenced in this FAQ, but those items typically do not require active administration or monitoring by a third party. The key step for any employer to protect valuable tax savings created by the plan is to have a document in place that authorizes pre-tax deductions by eligible employees. 

Simple 125 was established to provide an efficient and effective solution for employers and advisors. With the plan document in place, remaining responsibilities of the employer can be handled with education and advising. While ongoing plan monitoring or assistance is not included in the service, contact us for any specific questions and we will do our best to assist you.