What is Section 125?

Section 125 of the Internal Revenue Code, established in 1978, is a powerful tool that allows employees to pay for certain tax incentives or benefits with pre-tax dollars. While business owners have Section 179 and real estate investors have the 1031 exchange, Section 125 is one of the few significant tax deductions available to employees. This article will explore the ins and outs of Section 125 and how it can benefit both employers and employees.

Section 125 (cafeteria) plans enable employers to offer their employees the option to pay for qualified benefits with pre-tax dollars. This is typically done through a cafeteria plan, which is an employer-sponsored program that allows employees to choose between taxable and non-taxable benefits, both with different tax incentives.

Reasons Companies Use Section 125 Plans

Companies incorporate Section 125 plans as part of their benefit offerings to employees for a number of reasons.

• Supplementary Healthcare: Section 125 plans often cover health benefits beyond the scope of standard health coverage, catering to employees’ specific needs.
• Major Medical Alternative: If an employee is ineligible for major medical coverage, paying for Section 125 plans offers them alternative care.
• Cost-Sharing Premiums: Certain companies pay for a percentage of major medical, dental, and vision premiums, leaving the employee to use their salary to pay for their share of the premiums
• Flexibility: Section 125 plans are voluntary programs, encouraging employees to choose benefits that best suit their needs.
• Employee Tax Savings: When employees are on a Section 125 plan, their taxable income goes down, saving them on federal, FICA, and potentially state/city taxes.
• Reduced Payroll Taxes: Employers save on their share of FICA taxes (~7.65%) for every dollar employees contribute to the plan.

Eligible Benefits, Tax Incentives, and Section 125 Plans

Section 125 plans can take on a variety of forms. Here are the most popular ones:

• Health Insurance Premiums
• Dental and Vision Insurance Premiums
• Flexible Spending Accounts (FSAs)
• Health Savings Accounts (HSAs)
• Dependent Care Assistance Plans (DCAPs)
• Employee Assistance Programs (EAPs)
• Wellness Programs
• Group Term Life Insurance
• Cancer, Disability, Accident Insurance

Traditionally, when most employers think of Section 125, they think of FSAs or HSAs. However, while they are beneficial for tax deductions, they still hold several limitations.

An FSA is an employer-sponsored benefit that allows employees to set aside pre-tax dollars for eligible medical expenses (co-payments, deductibles, exams, treatments). However, FSAs come with a “use it or lose it” clause, meaning unspent funds at the end of the year may be forfeited at the end of the year and retained by the employer. FSAs typically do not allow for carrying large amounts year-to-year and have a $3,200 contribution limit for 2024.

An HSA is a tax-advantaged savings account designed for employees with high-deductible health plans (HDHPs). While HSAs offer the benefit of rolling over unused funds and earning interest, they also require individuals to maintain a high-deductible plan (an annual deductible of $1,600 or more in 2024) and have annual contribution limits ($4,150 for single and $8,300 for married in 2024).

The Flex Health Difference

Flex Health offers a unique approach to Section 125 plans, focusing on preventative care and overcoming the limitations of traditional FSAs and HSAs (and with higher tax incentives):

• No “use it or lose it” clause: Unlike FSAs, employees on Flex Health are contributing to an insurance policy rather than an account. Eligible employees receive a claim payment each month, ensuring no reimbursable funds are left over at the end of the year.
• Positive impact for both employees and employers: The Flex Health plan is designed to create a net positive financial outcome for all parties involved.
• Comprehensive preventative care: By emphasizing preventative health measures, Flex Health aims to reduce long-term healthcare costs and improve employee well-being.
• Greater employee retention: By offering this program, employers are boosting employee’s take-home pay while equipping them with several $0 co-pay benefits.

How it Works

Flex Health operates through a salary reduction agreement, where employees agree to reduce their salary by a certain amount each month to pay for qualified premiums. This reduction happens before W-2 taxes are calculated, resulting in lower taxable income for the employee, higher tax incentives, and reduced payroll (FICA) taxes for the employer.

Each month (split even across bi-weekly payroll periods) the employee receives a claim payment from the carrier totaling ~84% of their pre-tax premiums as long as they complete a qualified activity. Most employees utilize the digital health coaching component, receiving this fixed indemnity payment directly back into their paycheck, in the same payroll cycle the premium was withdrawn.

For example, if an employee has a $5,000 monthly salary and is enrolled in the $1,200/month premium plan:

• Taxable income (before other active deductions) is reduced to $3,800 per month.
• Employee saves federal, social security, medicare, and state/city taxes.
• Employer saves on their share of FICA taxes.
• Employee receives a $1,000 indemnity payment back into their paycheck from the carrier. This payment is below the “excess benefit” threshold and excluded from taxable income.
• The employee’s tax savings are in excess of the remaining cost of the program.

Below is a diagram to better illustrate this adjustment:

Flex Health only qualifies those employees who have enough taxable income and unused deductions such to see an increase in their net take-home pay.

The Bottom Line

Section 125 offers significant tax incentives for both employees and employers. By leveraging these benefits, companies can provide valuable health and wellness options to their workforce while simultaneously reducing their tax burden. Flex Health takes this concept a step further by focusing on preventative care and eliminating some of the drawbacks associated with traditional Section 125 plans.

As healthcare costs continue to rise, it’s more important than ever for employers to explore innovative solutions like Flex Health and provide comprehensive benefits while maximizing underutilized tax incentives. By embracing the power of Section 125 and the unique approach offered by Flex Health, companies can create a win-win situation that promotes employee well-being and financial health for all parties involved.