Most employers who search how to set up a Section 125 plan have already seen the numbers. Pre-tax premium deductions cut payroll taxes for the company and raise take-home pay for employees. The hard part is knowing what to do first, what the IRS actually requires, and what payroll can and cannot handle alone. This guide walks through each setup step in order, with the rules and a worked example.
What Is a Section 125 Plan?
A Section 125 plan, also called a cafeteria plan, is a written employer plan that lets employees pay for certain benefits with pre-tax salary reductions. Internal Revenue Code Section 125 creates the tax break. The money employees put toward eligible benefits is not subject to federal income tax or FICA (Federal Insurance Contributions Act) payroll tax.
FICA is 7.65% for the employee and 7.65% for the employer, per the IRS. Every pre-tax dollar an employee elects saves the employer 7.65 cents in FICA and saves the employee FICA plus income tax. For a full walkthrough of the rules, see the Section 125 cafeteria plan guide.
Who Can Set Up a Section 125 Plan?
Any employer with W-2 employees can set up a Section 125 plan, including C corporations, S corporations, partnerships, LLCs, sole proprietors and nonprofits. There is no minimum company size. A business with 2 employees and a business with 2,000 employees follow the same core rules.
The limit is on who can participate. Under Proposed Treasury Regulation Section 1.125-1(g), sole proprietors, partners in a partnership and shareholders who own more than 2% of an S corporation cannot pay for benefits pre-tax through the plan. The business can still sponsor the plan for its W-2 employees.
How Do You Set Up a Section 125 Plan Step by Step?
An employer sets up a Section 125 plan in eight steps. The order matters, because the IRS requires the written plan to exist before the first pre-tax deduction.
Step 1: Choose the plan type
The employer decides which benefits the plan will cover. The three most common designs are:
| Plan type | What employees can pay pre-tax | Best fit |
|---|---|---|
| Premium only plan (POP) | Their share of health, dental and vision premiums | Small employers starting simple |
| POP plus flexible spending accounts | Premiums, plus a health FSA and a dependent care FSA | Employers whose staff have medical or child care costs |
| Full cafeteria plan | Premiums, FSAs, HSA contributions and other qualified benefits | Employers who want a broad pre-tax menu |
A premium only plan is the fastest to launch. The premium only plan guide explains when a POP is enough.
Step 2: Set the plan year and effective date
The plan year is the 12-month period the elections cover. Most employers match the Section 125 plan year to the health insurance renewal date, so premium changes and elections line up. A plan can start mid-year, but the first plan year is then a short plan year.
Step 3: Adopt a written plan document
The employer must sign a written plan document on or before the first day of the plan year, under Proposed Treasury Regulation Section 1.125-1(c). The plan document must describe each benefit, eligibility rules, election procedures, how contributions are made, the maximum salary reduction and the plan year. A payroll setting is not a plan document. Pre-tax deductions taken before the plan is signed are taxable wages.
Step 4: Prepare the summary plan description and employee materials
Health FSAs and group health coverage are ERISA (Employee Retirement Income Security Act) plans, so employees must receive a summary plan description. Employees also need a clear election form that shows the benefit, the amount and the pre-tax treatment.
Step 5: Set up payroll deduction codes
The payroll provider creates pre-tax deduction codes for each benefit. Each code must be exempt from federal income tax withholding, Social Security, Medicare and federal unemployment tax. Most states follow the federal treatment, but the payroll provider should confirm state rules for each work location.
Step 6: Collect employee elections
Each employee signs a salary reduction election before the plan year starts. Under Treasury Regulation Section 1.125-4, the election is locked for the plan year unless the employee has a permitted change event, such as marriage, a birth or loss of other coverage. New hires elect when they become eligible.
Step 7: Run nondiscrimination testing
Section 125 plans must not favor highly compensated or key employees, under Internal Revenue Code Section 125(b) and (c). For 2026 testing, a highly compensated employee is generally someone who earned more than $160,000 in the prior year, per IRS Notice 2025-67. Key employees cannot receive more than 25% of the plan's total nontaxable benefits. Employers with 100 or fewer employees can use a simple cafeteria plan to be treated as passing these tests, if the employer makes the required contribution.
Step 8: Run the plan and repeat each year
After launch, the employer reports pre-tax amounts correctly on Form W-2, runs open enrollment before each new plan year, re-tests for nondiscrimination and updates the plan document when limits change. The cafeteria plan itself does not file Form 5500, per IRS Notice 2002-24. A health FSA with 100 or more participants may need its own Form 5500 as an ERISA welfare plan.
How Long Does It Take to Set Up a Section 125 Plan?
Most employers can set up a Section 125 plan and run the first pre-tax deduction in 3 to 6 weeks. The plan document can be ready in days. Payroll configuration and election collection usually take the longest. The Section 125 implementation timeline breaks the work down week by week and lists what commonly delays the first deduction.
What Are the 2026 Limits to Put in the Plan Document?
The plan document should state the limits the employer will use for the plan year. The key 2026 figures are:
| Benefit | 2026 limit | Source |
|---|---|---|
| Health FSA salary reduction | $3,400 per employee | IRS Revenue Procedure 2025-32 |
| Health FSA carryover (if offered) | $680 | IRS Revenue Procedure 2025-32 |
| Dependent care FSA | $7,500 per household ($3,750 married filing separately) | One Big Beautiful Bill Act |
| Premium payments through POP | No IRS dollar cap; limited to the employee's actual premium share | Internal Revenue Code Section 125 |
The dependent care FSA increase to $7,500 is optional. An employer that wants the higher limit must write it into the plan document.
How Much Does a Section 125 Plan Save? A Worked Example
A Section 125 plan saves the employer 7.65% of every dollar employees elect pre-tax. The employee saves the same 7.65% plus federal and most state income tax on that amount.
Take a company with 20 enrolled employees. Each employee pays $400 a month toward health premiums through payroll.
- Monthly pre-tax premium deductions: 20 x $400 = $8,000
- Employer FICA avoided: $8,000 x 7.65% = $612 a month, or $7,344 a year
- Employee FICA avoided: $30.60 per employee per month ($400 x 7.65%)
- Employee income tax avoided: at a 12% federal bracket, another $48 per employee per month
Larger pre-tax elections produce larger savings. The KFF 2025 Employer Health Benefits Survey found workers with family coverage paid an average of $6,850 a year toward premiums, about $571 a month. The FICA tax savings breakdown shows how the math scales by payroll size.
Should You Set Up a Section 125 Plan Yourself or Use an Administrator?
An employer can set up a Section 125 plan alone, but it must write or buy a compliant plan document, draft the summary plan description, design election forms, configure payroll correctly and run nondiscrimination tests each year. Missing a step can turn every pre-tax deduction into taxable wages, as the page on Section 125 cafeteria plan penalties explains.
Most small and mid-size employers use a plan administrator. Summit Health Benefits is a Section 125 plan administrator that provides a written plan document, a summary plan description and nondiscrimination testing support, with plan documents reviewed by ERISA attorneys.
Summit's admin fee is $35 per enrolled employee per month (PEPM). That fee is paid out of the employer FICA savings the plan creates. Summit's plan design typically recaptures $91 to $136 in employer FICA per enrolled employee per month, so the employer nets about $56 to $101 per enrolled employee per month after the fee. Actual savings depend on how much each employee elects pre-tax, so Summit models the numbers on the employer's payroll before setup. The Section 125 plan cost page covers pricing in full, and the savings calculator gives a quick estimate.
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Frequently Asked Questions
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Sources: Internal Revenue Code Section 125, including Sections 125(b), 125(c) and 125(j); Proposed Treasury Regulation Sections 1.125-1(c) and 1.125-1(g), Federal Register (2007); Treasury Regulation Section 1.125-4 (permitted election changes); IRS, Topic 751 and Publication 15 (2026 FICA rates of 7.65% for employers and employees); IRS Revenue Procedure 2025-32 (2026 health FSA limit of $3,400 and $680 carryover); IRS Notice 2025-67 (2026 highly compensated employee threshold); One Big Beautiful Bill Act (2025), dependent care assistance limit of $7,500 beginning in 2026; IRS Notice 2002-24 (suspension of Form 5500 filing for cafeteria plans); KFF, 2025 Employer Health Benefits Survey (average worker contribution of $6,850 for family coverage).