What is a Section 125 plan, in plain English?

A written plan under Internal Revenue Code §125 that lets employees pay their share of premiums (and, with an FSA, eligible expenses) with pre-tax dollars. The employee skips federal income tax and 7.65% FICA on those dollars; the employer skips its matching 7.65% FICA. It requires a plan document, annual nondiscrimination testing and payroll set-up — it is not a product you buy.

How much does a Section 125 plan save an employer?

7.65% of every pre-tax dollar employees contribute, minus plan-document and administration costs. Twenty employees contributing $500 a month is $120,000 a year pre-tax and about $9,180 of employer FICA avoided — the calculator nets out the costs on your numbers.

Is the 'wellness plan that pays employees cash back tax-free' legal?

The IRS says the cash is taxable wages. Chief Counsel Advice 202323006 (2023) held that fixed-indemnity wellness payments funded with pre-tax premiums are wages subject to income tax and FICA when the employee has no unreimbursed medical expense, and IR-2024-65 and the 2024 final rule reinforced it. California's Department of Insurance issued a cease-and-desist against a related program. We do not sell those plans.

Who cannot participate in a Section 125 plan?

Self-employed owners: sole proprietors, partners, and more-than-2% S-corporation shareholders (and certain family members) cannot participate on a pre-tax basis. C-corporation owner-employees can.

Does Section 125 work in every state?

Federal income tax and FICA treatment is national. State income tax treatment is generally the same, with New Jersey a notable exception that does not conform to §125 for state income tax.

Section 125

The Compliant Payroll-Tax Savings, Set Up Right

What a Section 125 plan is, exactly who saves what, who cannot participate, and the IRS warnings that separate the real thing from the "wellness" schemes.

Quick answer

Under IRC §125, employees can pay their share of premiums (and FSA contributions) before federal income tax and FICA. The employee avoids income tax at their bracket plus 7.65% FICA; the employer avoids its matching 7.65% FICA. It needs a written plan document, nondiscrimination testing and payroll coding. Sole proprietors, partners and more-than-2% S-corp shareholders cannot participate pre-tax. New Jersey does not conform for state income tax.

Who Saves What

The Employee

Federal income tax at their bracket (22% for many households) plus 7.65% FICA on every pre-tax dollar. $500 a month of premium share at the 22% bracket is about $1,779 a year kept.

The Employer

7.65% FICA on the same dollars. Twenty participants at $500 a month is $120,000 pre-tax and about $9,180 of employer FICA avoided, before plan costs.

Premium-Only Plan Vs FSAs

	Premium-only plan (POP)	Health FSA	Dependent-care FSA
What goes pre-tax	Employee premium share	Eligible medical expenses	Child or dependent care
2026 limit	No statutory cap (premium amount)	$3,400 (2027 not yet released)	$7,500 (married filing jointly)
Use-it-or-lose-it	No	Yes, with carryover or grace period if adopted	Yes
Admin cost	Lowest	Per-participant monthly fee	Per-participant monthly fee

2026 FSA limits per Rev. Proc. 2025-32 (health FSA $3,400; dependent-care FSA $7,500 married filing jointly); the IRS usually releases the next year's limits in late October or November. Verify before plan-year adoption.

Not a Section 125 plan: programs that pay employees "tax-free" cash for wellness activities funded by pre-tax premiums. IRS Chief Counsel Advice 202323006 treats those payments as taxable wages; the 2024 final rule and IR-2024-65 reinforced it; California's insurance regulator issued a cease-and-desist against a related program. Groom Law Group on CCA 202323006; The Tax Adviser, Nov 2023; California Department of Insurance, July 2025; Steptoe, June 2026.

How We Set One Up

Plan Document

Adopted before the plan year, naming eligible employees, benefits and the plan year. A third-party administrator prepares it; we quote the fee up front.

Payroll Coding

Deductions coded pre-tax for federal income tax and FICA; state treatment checked (New Jersey differs).

Testing & Notices

Annual nondiscrimination testing and the summary plan description to employees; owners excluded where the code requires.

Run The Savings Calculator Set Up A Section 125 Plan