Understanding Section 125 and Its Advantages for Businesses and Employees

A Section 125 cafeteria plan can save your business 7.65% in payroll taxes for every employee enrolled — and save your employees 22-30% on the cost of their benefits. Here’s how the plan works, what it covers, and how Texas businesses use Section 125 to make their benefits package more competitive without raising payroll.

What Is a Section 125 Cafeteria Plan?

A Section 125 plan — named after Section 125 of the Internal Revenue Code — lets employees pay for certain benefits with pre-tax dollars instead of after-tax dollars. The “cafeteria” nickname comes from the fact that employees can pick and choose which benefits to fund (health insurance, FSAs, dependent care, etc.), the way you’d choose items in a cafeteria line.

The mechanic is straightforward: the employee tells payroll how much of their salary to redirect into eligible benefits. That portion never shows up as taxable income, which means:

• Employees pay less in federal income tax, Social Security, and Medicare — typical savings of 22-30% on benefit dollars.
• Employers pay less in matching FICA taxes (7.65%) on the same dollars — directly reducing payroll tax liability.
• Both sides win from the same plan structure, with no out-of-pocket cost to the business.

How a Section 125 Plan Works

A Section 125 plan operates through four mechanics:

1. Salary reduction. The employee elects how much of their gross wages to redirect into pre-tax benefits during open enrollment.
2. Pre-tax contributions. Payroll deducts the elected amount before applying federal income tax, Social Security, or Medicare.
3. Tax savings show up immediately. Because the contribution never counted as income, both the employee and employer skip the taxes that dollar would have triggered.
4. Elections lock for the plan year. Employees can only change their elections during open enrollment or after a qualifying life event (marriage, divorce, birth/adoption, employment change).

How Much Can a Section 125 Plan Save Your Business?

Real numbers, using a Texas employer with 10 employees averaging $55,000 in wages, each contributing $400/month ($4,800/year) to pre-tax health insurance premiums and an FSA:

• Per employee, per year: $4,800 × 7.65% = $367 in employer payroll tax savings
• Across 10 employees: roughly $3,670 saved annually for the business
• Each employee saves separately: $4,800 × ~25% effective tax rate = $1,200/year in personal taxes — which means each employee effectively gets a $1,200 raise without you spending more on payroll

For most small and mid-sized Texas employers, a Section 125 plan pays for its own setup and administration costs in the first quarter and continues delivering returns indefinitely.

What Benefits Can Go in a Section 125 Plan?

The IRS allows specific categories of benefits to be paid pre-tax through a Section 125 plan:

• Group health insurance premiums (employee portion)
• Health Savings Accounts (HSAs) when paired with a qualifying high-deductible health plan
• Flexible Spending Accounts (FSAs) for medical expenses
• Dependent Care Assistance Programs (DCAPs)
• Group term life insurance (up to $50,000 in coverage)
• Adoption assistance
• Disability insurance premiums

What’s NOT eligible: long-term care insurance, employer-provided meals or lodging, transportation benefits, and most other fringe benefits. If you’re considering bundling a benefit into a Section 125 plan, confirm it’s on the IRS-approved list before structuring the plan around it.

How to Set Up a Section 125 Plan in Texas

A Section 125 plan requires a written plan document, payroll integration, and annual compliance testing. Here’s the path most Texas employers follow:

1. Decide which benefits to include. Most plans start with health insurance premiums, then add FSAs and DCAPs as the team grows. A free benefits audit identifies the highest-leverage benefits for your specific team.
2. Draft a written plan document. The IRS requires a formal plan document covering eligibility rules, contribution limits, election procedures, and compliance. Most brokers and TPAs provide template plan documents that fit standard small-business needs.
3. Configure payroll. Your payroll provider needs to know which deductions to apply pre-tax. Most platforms (Gusto, ADP, Paychex, QuickBooks) support Section 125 deductions natively.
4. Run open enrollment. Employees elect their pre-tax contribution amounts. Provide written summary plan descriptions (SPDs) so employees understand their options.
5. Conduct annual nondiscrimination testing. The IRS requires testing each plan year to confirm benefits aren’t disproportionately favoring highly compensated employees. Most TPAs run this automatically.

At Medcore Brokerage, we handle plan document drafting, payroll coordination, and compliance testing for Texas businesses as part of our standard onboarding — so you can offer a Section 125 plan without adding to your HR workload.

Ready to set up a Section 125 plan for your Texas business? Call (972) 277-1049 or request a free benefits audit. We’ll review your current benefits, model the tax savings, and handle the compliance work.

Section 125 Compliance & Nondiscrimination Testing

The IRS requires Section 125 plans to pass nondiscrimination tests annually. The tests confirm that highly compensated employees, key employees, and shareholders aren’t receiving disproportionately better treatment than rank-and-file staff. The three main tests:

• Eligibility test: The plan must be available to a fair cross-section of employees, not just executives.
• Benefits test: Highly compensated employees can’t receive substantially better benefits than other employees.
• Key employee concentration test: Key employees can’t receive more than 25% of the total nontaxable benefits paid through the plan.

Failing any of these tests means highly compensated employees lose the tax-advantaged status of their contributions for that plan year — meaning those contributions become taxable as regular income. Rank-and-file employees aren’t affected. Most brokers and TPAs run the testing automatically as part of plan administration.

Section 125 Contribution Limits (2025)

• Healthcare FSA: $3,300 maximum employee contribution per year (with up to $640 rollover if the employer offers it)
• Dependent Care Assistance Program: $5,000 per household per year
• HSA (when paired with qualifying HDHP): $4,300 individual / $8,550 family
• Group term life insurance: Up to $50,000 in coverage paid pre-tax

The IRS adjusts these limits annually for inflation. Confirm current-year limits when designing or renewing your plan.

Section 125 Cafeteria Plan FAQs

Do Section 125 cafeteria plans require IRS approval?
No — but they must follow IRS guidelines, including a formal written plan document, eligibility rules, and annual nondiscrimination testing. The plan document doesn’t get filed with the IRS unless audited, but it must exist and be available on request.

Can a small business with 10 employees offer a Section 125 plan?
Yes. Section 125 plans work at any company size. Most Texas small businesses with 10 or more employees see meaningful payroll tax savings, often $3,000–$5,000 annually depending on participation rates.

Can employees change their elections during the year?
Only after a qualifying life event — marriage, divorce, birth or adoption of a child, change in spouse’s employment, or change in dependent care needs. Outside those events, elections lock for the plan year.

What happens to unused FSA funds at the end of the year?
Healthcare FSAs are typically “use it or lose it” unless the employer offers a rollover (up to $640 in 2025) or a 2.5-month grace period. Dependent care FSAs don’t allow rollovers — unused funds are forfeited.

How does a Section 125 plan affect ACA compliance?
The benefits offered through the cafeteria plan must still meet ACA standards. Employers with 50+ full-time-equivalent employees must offer minimum essential coverage that meets affordability and minimum-value tests, regardless of how it’s funded.

What’s the employer’s role once the plan is running?
Maintain the plan document, run payroll deductions accurately, complete annual nondiscrimination testing, and provide employees with summary plan descriptions and election forms during open enrollment. Most of this is handled by your benefits broker or third-party administrator.

What happens if our plan fails nondiscrimination testing?
Highly compensated employees lose the tax-advantaged status of their contributions for that plan year — meaning those contributions become taxable as regular income. Rank-and-file employees aren’t affected. The fix is usually adjusting plan design or contribution structure for the next plan year.

Can I use a Section 125 plan with ICHRA?
Yes — Section 125 plans work alongside ICHRA arrangements. Employees can pay any uncovered premium balance through pre-tax payroll deductions. This combination is increasingly popular with Texas small businesses managing variable group health costs.

Set Up a Section 125 Plan for Your Texas Business

Medcore Brokerage helps Texas employers design, implement, and maintain Section 125 cafeteria plans as part of a complete employee benefits package. We handle the plan document, payroll coordination, employee education, and annual compliance testing — so the only thing you have to do is sign off on the design.

Get started: Call (972) 277-1049 for a 10-minute discovery call, or request a free benefits audit and we’ll model the exact tax savings for your team. You can also explore our other benefits articles for related topics like ICHRA, group health plans, and disability coverage.