insurance

Section 125 Plan

A cafeteria plan authorized by Section 125 of the Internal Revenue Code that allows employees to pay for certain benefits with pre-tax dollars. Employees can choose from a menu of benefits including health insurance, dental coverage, dependent care assistance, and flexible spending accounts, reducing their taxable income.

Example

“Through her company's Section 125 plan, Jennifer elected to contribute $3,000 annually to a flexible spending account for medical expenses, saving her approximately $900 in taxes.”

Memory Tip

Remember '125 = Save Money' - Section 125 plans help you save money on taxes by paying for benefits before taxes are calculated.

Why It Matters

Section 125 plans can save employees significant money by reducing their taxable income, often saving 20-40% on benefit costs through tax savings. For employers, these plans reduce payroll taxes and can be a valuable tool for attracting and retaining employees without increasing actual compensation costs.

Common Misconception

Many employees think Section 125 plans are just about health insurance, but these plans can include various benefits like dependent care, transportation, and flexible spending accounts. Additionally, some believe unused FSA money can be carried over indefinitely, when most plans have 'use it or lose it' rules with limited carryover options.

In Practice

Mark earns $60,000 annually and is in the 22% tax bracket plus 7.65% for FICA taxes. Through his Section 125 plan, he contributes $2,400 to health insurance and $1,200 to a medical FSA, totaling $3,600 in pre-tax deductions. This reduces his taxable income to $56,400, saving him approximately $1,067 in federal taxes ($792) and FICA taxes ($275). Instead of paying $3,600 for these benefits after taxes, he effectively pays only $2,533, saving over $1,000 annually.

Etymology

Named after Section 125 of the Internal Revenue Code, which was added in 1978 and later expanded to allow employees to choose between cash and qualified benefits without creating taxable income.

Common Misspellings

Section 125 PlansSection 125 PlaneSection 125 PlanSection 125 Plan

Related Terms

flexible spending account

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