Section 125 Plans: Plain Answers for San Diego Employers

Section 125 plans can save money for your business and your employees, but the rules and the jargon can get confusing fast. Below are straight answers to the questions San Diego employers and employees ask us most.

Client Benefit Insurance Services (CBIS) is an independent agency in Santee that has helped local businesses with their benefits since 1982. If you’d rather talk it through, you can book a phone or video call benefits review anytime.

Common questions about Section 125 plans

What is a Section 125 plan?

A Section 125 plan, often called a cafeteria plan, is a written plan that lets employees choose between taking their regular pay and using part of it for certain tax-favored benefits. It’s named for Section 125 of the Internal Revenue Code, which says every participant must be an employee and the choices must include cash and at least one qualified benefit.

When an employee picks a qualified benefit, like their share of a health insurance premium, that amount comes out of their paycheck before taxes. The “cafeteria” nickname comes from choosing items off a menu.

Elections are usually made once a year at open enrollment. Under IRS rules, a plan can allow mid-year changes only for specific events, such as marriage, divorce, the birth or adoption of a child, or a change in a spouse’s job or coverage.

What is a Section 125 premium only plan (POP)?

A premium only plan (POP) is the simplest kind of Section 125 plan. IRS proposed regulations describe it as a cafeteria plan whose only benefit is letting employees pay their share of employer-sponsored accident and health insurance premiums with pre-tax pay instead of after-tax pay.

There are no spending accounts to manage and no claims to review. Payroll simply takes the employee’s share of the premiums out before taxes are figured.

Because it’s so simple, a POP is often where small employers start. It’s also how many employers let employees pay for eligible voluntary benefits, like accident or hospital indemnity coverage, before taxes. For more detail, see our article What is a Section 125 Premium Only Plan?

What benefits are included in a Section 125 plan?

IRS Publication 15-B lists the qualified benefits a cafeteria plan can include: accident and health benefits, adoption assistance, dependent care assistance, group-term life insurance, and health savings accounts (HSAs). The same publication lists benefits a cafeteria plan can’t include, such as educational assistance, commuting benefits, and long-term care insurance.

In everyday terms, that often means:

Medical, dental, and vision premiums
A health flexible spending account (FSA). For plan years beginning in 2026, employees can put in up to $3,400 through payroll.
A dependent care FSA for child care and other eligible dependent care costs
Group-term life insurance
Disability coverage
Supplemental coverage such as accident, critical illness, cancer, and hospital indemnity insurance, when it’s set up to qualify
HSA contributions, for employees enrolled in an HSA-eligible health plan

Permanent life insurance, like whole life, isn’t a qualified benefit under IRS rules. It can still be offered through payroll deduction, just on an after-tax basis.

One California note: the state doesn’t give HSAs the federal tax break. According to the California EDD, HSA contributions made through a Section 125 plan are still subject to state income tax withholding and State Disability Insurance (SDI).

What is a Section 125 supplemental health plan?

A “Section 125 supplemental health plan” usually means supplemental insurance, such as accident, critical illness, cancer, or hospital indemnity coverage, that employees pay for through payroll under the company’s Section 125 plan. IRS proposed regulations specifically allow cafeteria plans to include health policies that cover specific accidents or diseases or pay a fixed amount per day in the hospital.

These policies pay cash benefits to the employee after a covered event. That money can help with deductibles, travel for treatment, or everyday bills while someone recovers.

There is a trade-off to understand. IRS Publication 525 explains that when accident or health premiums are paid pre-tax through a cafeteria plan, the employee generally isn’t treated as having paid the premiums, so some benefits from that coverage, like disability income, can be taxable. That’s why some employers choose to offer certain policies, especially disability, on an after-tax basis.

Also, be careful with “wellness” or fixed indemnity programs pitched as a way to cut payroll taxes at little or no cost to employees. In a 2023 legal memo (CCA 202323006), the IRS Office of Chief Counsel concluded that wellness payments from this kind of plan are taxable wages when they don’t reimburse actual medical expenses.

Our team at CBIS focuses on Colonial Life voluntary benefits. We can walk you through how each policy is set up for payroll and what your employees should know. Learn more about our voluntary benefits.

How does a Section 125 plan reduce taxes?

Money an employee directs to qualified benefits through a Section 125 plan is generally excluded from federal income tax withholding, Social Security and Medicare (FICA) tax, and federal unemployment (FUTA) tax. Employees and employers each pay 7.65% in FICA tax on wages (6.2% Social Security plus 1.45% Medicare), so every pre-tax dollar saves both sides that tax.

Here’s a simple way to picture it. If an employee moves $100 a month of premiums to pre-tax, the employer’s matching FICA tax goes down by $7.65 a month. The employee saves the same $7.65, plus whatever federal income tax they would have paid on that $100. (Social Security tax only applies up to the annual wage base, which is $184,500 for 2026.)

In California, the EDD says pre-tax salary reductions for health, accident, group-term life, and dependent care benefits under a cafeteria plan are also not subject to state unemployment insurance (UI), the Employment Training Tax (ETT), State Disability Insurance (SDI), or state income tax withholding.

A few details to know. Adoption assistance is still subject to Social Security and Medicare tax, and group-term life coverage above $50,000 creates some taxable income. Also, because pre-tax dollars aren’t counted as Social Security wages, they don’t count toward the earnings Social Security uses to figure future benefits.

Your actual savings depend on your payroll, your employees’ tax situations, and which benefits you offer, so it’s worth running the numbers with your CPA.

Who is not eligible for a Section 125 plan?

Only employees can take part in a Section 125 plan, so sole proprietors, partners, and owners of more than 2% of an S corporation can’t participate, even though their business can sponsor a plan for its employees. For S corporations, IRS ownership attribution rules also treat the owner’s spouse, children, parents, and grandparents as more-than-2% owners, so they can’t participate either, even if they’re on payroll.

Others who generally can’t participate include:

Independent contractors paid on a 1099, since they aren’t employees
Board members who only serve as directors and don’t otherwise work for the company as employees
LLC members when the LLC is taxed as a partnership, since they’re treated as partners

Owners of a C corporation who work in the business as W-2 employees generally can participate.

Plans can also set their own eligibility rules, like a waiting period for new hires. To meet the nondiscrimination rules, though, a plan generally can’t require more than 3 years of employment before someone can join.

Do I need a Section 125 plan document?

Yes. Section 125 defines a cafeteria plan as a written plan, and IRS proposed regulations say that if there’s no written plan, employees’ pre-tax elections become taxable income.

The written plan has to be adopted and in effect on or before the first day of the plan year it covers. That applies to a simple POP as well as a plan with FSAs, and there’s no exception for small businesses.

You may see free or low-cost POP document templates from payroll companies and online vendors. Whatever you use, it should match how your plan actually works, including who’s eligible, which benefits are included, and your plan year. CBIS provides Section 125 plan documents for the employers we work with, and we can help keep them current as your benefits change.

Does CBIS set up the plan documents and payroll?

CBIS provides the Section 125 plan documents. We don’t run payroll ourselves, but we work with payroll partners who handle the payroll deduction side.

The plan document sets the rules, and payroll takes each employee’s elections out before taxes. If you need help on the payroll side, we can connect you with one of the payroll partners we work with.

How much does a Section 125 plan cost through CBIS?

If your business offers Colonial Life voluntary benefits through CBIS, the Section 125 plan is free, including annual plan document updates. Without those supplemental benefits, there is a fee for the Section 125 plan, so ask our team for pricing.

See if your business qualifies for a free Section 125 plan

Ask about pricing or talk through your setup with our team by phone or video call.

Book a benefits review

Or call (858) 283-7575.

What does “Sec 125” or “Med 125” mean on my paycheck or W-2?

On a pay stub, “Sec 125,” “S125,” or “Med 125” is a payroll label for money taken out of your pay before taxes through your employer’s Section 125 plan, usually for medical, dental, vision, or other insurance premiums. Because those dollars generally aren’t taxed, the wages in Box 1 of your W-2, and usually Boxes 3 and 5, will be lower than your total pay by that amount.

These labels aren’t official IRS terms, so the exact wording depends on your employer’s payroll system.

Some employers also list Section 125 amounts in the “Other” box of the W-2 just for your information. That’s Box 14, which became Box 14a on the 2026 form, and IRS instructions allow employers to use it for items like health insurance premiums deducted. You might also see Box 12 code DD, which shows the cost of employer-sponsored health coverage. That amount isn’t taxable.

If something on your W-2 doesn’t look right, your HR or payroll team is the best first stop.

What is an SPD (summary plan description) and a wrap document?

A summary plan description (SPD) is the plain-language guide to a benefit plan that ERISA, the federal law covering most private employer health and welfare plans, requires plan administrators to give participants. It generally has to be provided within 90 days after someone becomes a participant, or within 120 days after a new plan becomes subject to ERISA.

The U.S. Department of Labor describes the SPD as the document that tells participants what the plan provides and how it operates, including when they can join and how to file a claim. ERISA generally doesn’t apply to government or church plans.

A “wrap” document is an industry term, not a legal one. Insurance company certificates and benefit booklets often don’t include everything ERISA requires in an SPD, such as plan administrator details and a statement of ERISA rights. A wrap document “wraps around” those insurance documents to fill in the required information, and it can combine several benefits into one plan.

Small plans can still need one. Many fully insured plans with fewer than 100 participants don’t have to file the annual Form 5500, but Department of Labor rules say that exemption doesn’t remove the duty to provide an SPD.

A Section 125 plan document and an SPD do different jobs. The first sets up pre-tax payroll deductions, and the second explains the benefit plans to employees, so employers with group health coverage often need both.

Read more in our article What is a Wrap Summary Plan Description (SPD)?

Why do companies offer insurance benefits to employees?

Employers offer insurance benefits to attract and keep good people, and employees have come to expect them: 71% of private industry workers had access to employer medical care plans in March 2026, according to the U.S. Bureau of Labor Statistics. For a small business competing with larger companies for talent, a solid benefits package can make a real difference.

There are financial reasons too:

Employer contributions to employee insurance programs are generally deductible as a business expense.
A Section 125 plan lowers the payroll taxes the business pays on employee premium contributions.
Voluntary benefits are typically employee-paid, so you can add more choices without a big jump in your benefits budget.

Size matters too. Employers with 50 or more full-time employees, including full-time equivalents, are subject to the Affordable Care Act’s employer shared responsibility rules.

Benefits help employees, too. Good coverage and clear education help people handle a surprise medical bill or time away from work, and that peace of mind is something your team will notice. See our group benefits and voluntary benefits pages for more.

How CBIS helps San Diego employers

We work with businesses across San Diego County, with a focus on Colonial Life voluntary benefits, including:

Enrollment support, in person, by phone, or virtually
Benefits education, so employees understand what they’re choosing
Enrollment technology that makes signing up simple
Section 125 plan documents and annual updates, free when you offer Colonial Life voluntary benefits through CBIS
Coordination with our payroll partners, who handle the payroll deduction side

In a benefits review, we’ll look at what you offer today, how premiums run through payroll, and whether a Section 125 plan or voluntary benefits could help your team.

Talk with us about your benefits

Want help setting up a Section 125 plan?

Our team walks you through plan documents, Colonial Life voluntary benefits, and how premiums run through payroll. Meet by phone or video call.