How Does a Premium Only Plan Work for Small Businesses in 2026?

2026-06-09 • 9 min read

A premium only plan (POP) lets small businesses convert employee health insurance premiums into pre-tax deductions, reducing FICA taxes for the employer and income taxes for employees.

Quick Answer (as of 2026): A premium only plan (POP) is a type of Section 125 cafeteria plan that lets employees pay their share of health insurance premiums with pre-tax dollars. This reduces their federal income tax, FICA, and state income taxes simultaneously. Employers avoid paying 7.65% FICA on every pre-tax premium dollar, saving $91 to $136 per enrolled employee per month.

A premium only plan is the simplest and most widely used type of Section 125 cafeteria plan. It has one purpose: route the employee's share of health insurance premiums through payroll before taxes are calculated.

That single change reduces taxable wages for income tax purposes and for FICA. The employer saves on the employer-side FICA match. The employee takes home more pay. No investments. No benefits administration complexity. Just a written plan document and a payroll configuration.

What Is a Premium Only Plan?

A premium only plan (POP) is an IRS-qualified arrangement under Internal Revenue Code Section 125 that allows employees to pay their portion of employer-sponsored health insurance premiums with pre-tax payroll deductions.

The IRS defines a Section 125 cafeteria plan as a written plan under which employees choose between taxable cash compensation and nontaxable qualified benefits per IRS Publication 15-B. A premium only plan is the narrowest version of that structure, covering only premium contributions.

Without a POP, an employee earning $55,000 per year who contributes $300 per month to their health insurance pays income tax and FICA on that $300 before it goes to the insurer. With a POP, the $300 comes out before taxes, reducing taxable wages to $51,400 per year.

How Does the Tax Math Work?

The tax reduction stacks three layers for the employee and one for the employer.

For the employee contributing $300 per month ($3,600 per year):

Federal income tax savings (22% bracket): $66 per month
Social Security savings (6.2%): $18.60 per month
Medicare savings (1.45%): $4.35 per month
State income tax savings (varies by state, 4% to 9%): $12 to $27 per month

Combined employee take-home increase: approximately $70 to $110 per month per the FICA rates set by the IRS.

For the employer on the same $300 monthly election:

Employer FICA avoided (7.65%): $22.95 per month per employee
Annual employer FICA savings at 10 enrolled employees: $2,754

Summit Health Benefits handles the plan setup so employers do not need to configure this manually. You can calculate your exact savings here.

Who Qualifies for a Premium Only Plan?

Any employer who offers a group health insurance plan and has at least one W-2 employee qualifies to establish a premium only plan. The IRS does not set a minimum employee count for POPs under IRC Section 125.

Key eligibility rules per the IRS:

The employer must sponsor a group health plan.
Only W-2 employees may participate. Sole proprietors, partners, members of an LLC taxed as a partnership, and S-corp owners with more than 2% ownership cannot participate.
The plan must be in writing and adopted before the first pre-tax deduction.
Elections must be made before the plan year begins (prospective elections only).

Self-employed individuals with Schedule C income and more than 2% S-corp shareholders can deduct premiums on their personal returns through a different mechanism, but they cannot route those premiums through a POP.

Premium Only Plan vs. Full Cafeteria Plan

A premium only plan is narrower than a full Section 125 cafeteria plan. Here is how they differ.

Feature	Premium Only Plan	Full Cafeteria Plan
Health insurance premiums	Yes	Yes
Health FSA contributions	No	Yes
Dependent care FSA	No	Yes
Dental and vision premiums	Yes (if offered)	Yes
COBRA premiums	Yes	Yes
Plan document required	Yes	Yes
Nondiscrimination testing	Yes (simplified)	Yes (more complex)
Administrative complexity	Low	Moderate
Annual setup cost	Low	Moderate to high

Most small businesses start with a premium only plan. Adding an FSA is a separate election that can be added at renewal.

What Does a POP Plan Document Include?

The IRS requires a written plan document as a prerequisite for a valid Section 125 plan per IRS Notice 89-61. Without a signed plan document in place before the first pre-tax deduction, the deductions are not legally pre-tax and the employer faces potential payroll tax liability plus penalties.

A valid POP plan document must include:

The plan year start and end dates
A description of the benefits offered (health, dental, vision premiums)
Eligibility criteria (employee class, waiting periods)
Election procedures (how employees enroll, deadlines)
Rules for mid-year election changes (qualifying life events per IRS Notice 2022-41)
Nondiscrimination testing provisions

Summit Health Benefits provides IRS-compliant plan documents for all enrolled employers. Get started here.

How Much Does a Premium Only Plan Cost?

Summit Health Benefits charges $35 per enrolled employee per month to administer a premium only plan. This covers the plan document, payroll coordination, nondiscrimination testing support, and compliance maintenance.

The employer typically recovers the fee through FICA savings alone when employees contribute at least $457 per month to premiums ($35 / 7.65% = $457). Below that threshold, the employer still benefits from reduced employee turnover and the employee gains the income tax reduction.

For a 10-person business with each employee contributing $400 per month:

Monthly pre-tax contributions: $4,000
Employer FICA avoided: $306 per month ($4,000 × 7.65%)
Monthly admin fee: $350 ($35 × 10 employees)
Net employer savings: −$44 per month in FICA (but employees gain $70-$110/month each in take-home pay, improving retention)
At $500/month per employee contributions: Net employer savings = $382.50 − $350 = +$32.50/month

The FICA savings calculator runs this math with your actual payroll numbers.

How to Set Up a Premium Only Plan in 5 Steps

Setting up a premium only plan takes approximately four to five weeks for a small business.

Confirm group health plan coverage. The employer must already offer or be in the process of offering a group health plan. A POP cannot exist without an underlying group health insurance policy.

Execute a written plan document. The plan document must be signed before the first pre-tax deduction is processed. Retroactive plan documents are not valid under IRS rules. Summit Health Benefits prepares compliant plan documents as part of enrollment.

Set a plan year. Most small businesses align the POP plan year with the health insurance policy year (often January 1 or the group health renewal date). The plan year cannot be changed without a valid business reason per IRS Rev. Rul. 2002-32.

Collect employee elections. Employees must sign enrollment forms electing the pre-tax deduction amount before the plan year begins. New hires have a 30-day window from their hire date to make their initial election.

Configure payroll. The payroll system must be updated to process the §125 deduction before calculating federal and state income taxes and FICA. Most payroll systems (ADP, Paychex, Gusto, QuickBooks Payroll) support pre-tax deductions with a specific benefit code.

Can a Premium Only Plan Reduce State Taxes?

Yes, in most states. Because South Carolina, Georgia, North Carolina, and most other states conform to federal W-2 wage definitions, the same Box 1 wage reduction that reduces federal taxable income also reduces state taxable income. Health insurance premium increases in 2026 make pre-tax treatment increasingly valuable.

States that do not conform to federal §125 exclusions (New Jersey is the primary example) require separate state income tax withholding on premium amounts even after a pre-tax election. New Jersey taxes §125 elections as regular wages for NJ gross income tax purposes, which reduces but does not eliminate the employee's tax savings.

Do Small Businesses Need to File Anything with the IRS?

No separate IRS filing is required to establish or maintain a premium only plan. The plan document is maintained internally. The pre-tax elections are reflected on employee W-2 forms in Box 1 (reduced wages) and Box 12 (Code DD for employer-sponsored coverage).

Employers do not file Form 5500 for premium only plans with fewer than 100 participants. Plans with 100 or more participants may be subject to Form 5500 filing requirements per the Department of Labor.

Summit Health Benefits handles POP setup for small businesses. Written plan document, payroll coordination, and ongoing compliance for $35 per enrolled employee per month. Get your savings estimate.

Frequently Asked Questions

What is the difference between a premium only plan and a Section 125 plan?

A premium only plan (POP) is a type of Section 125 cafeteria plan. Section 125 is the IRS code section that enables pre-tax benefit elections. A POP is the simplest version, covering only health insurance premiums. A full Section 125 cafeteria plan can also include health FSAs, dependent care FSAs, and other qualified benefits. Most small businesses start with a POP and add FSA options at renewal.

Can a business with only one employee use a premium only plan?

Yes. The IRS does not require a minimum number of employees to establish a Section 125 premium only plan. A business with one W-2 employee who contributes to employer-sponsored health insurance premiums can use a POP. The only requirement is a written plan document and a valid group health insurance policy. The sole proprietor or owner cannot participate if they are not a W-2 employee of the business.

How does a premium only plan affect an employee's W-2?

A premium only plan reduces the wages reported in Box 1 (federal taxable wages) of the employee's W-2 by the amount of pre-tax premium elections made during the year. Social Security wages in Box 3 and Medicare wages in Box 5 are also reduced. If the employer offers employer-sponsored health coverage, the combined employer and employee premiums may be reported in Box 12 with Code DD. The reduced Box 1 wages also flow to most state income tax returns.

Can employees change their premium only plan election during the year?

No, not without a qualifying life event. IRS rules require that Section 125 elections be irrevocable for the plan year unless the employee experiences a qualifying life event such as marriage, divorce, birth or adoption of a child, loss of other coverage, or a change in employment status. IRS Notice 2022-41 expanded the list of permitted change events for ACA marketplace coverage. Outside of these events, the election amount cannot be changed until the next plan year.

Does a premium only plan require nondiscrimination testing?

Yes. Section 125 plans including premium only plans must pass nondiscrimination tests under IRC Section 125(b) to verify the plan does not disproportionately benefit highly compensated employees or key employees. Three tests apply: the eligibility test, the contributions and benefits test, and the key employee concentration test. A failed test means highly compensated employees lose the pre-tax treatment on their elections. Summit Health Benefits provides annual nondiscrimination testing support as part of plan administration.

What happens to a premium only plan if an employee leaves?

When an employee terminates employment, their Section 125 election ends with the last paycheck. Any remaining plan year after termination does not require continued elections. The employer stops the pre-tax deduction effective the termination date. COBRA continuation coverage applies to the underlying group health plan, but COBRA premiums paid by a former employee after termination are typically paid on an after-tax basis unless the employer extends POP participation to COBRA participants in the plan document.

Can an S-corp owner use a premium only plan?

No. S-corporation shareholders who own more than 2% of the company's stock cannot participate in a Section 125 plan per IRS Notice 2008-1. This includes more than 2% shareholders and their spouses, parents, and children. A more than 2% S-corp shareholder can deduct health insurance premiums paid by the corporation as an above-the-line deduction on their personal Form 1040, but cannot route those premiums through a POP to avoid FICA.

How does a premium only plan interact with the ACA employer mandate?

A premium only plan does not affect ACA employer mandate compliance under IRC Section 4980H. Employers with 50 or more full-time equivalent employees must offer minimum essential coverage regardless of whether they have a POP in place. A POP only determines the tax treatment of employee premium contributions. The underlying group health plan must independently meet ACA minimum value and affordability standards. Summit Health Benefits can review affordability calculations for applicable large employers.

Sources: IRS Publication 15-B (Employer's Tax Guide to Fringe Benefits); Internal Revenue Code Section 125; IRS Notice 89-61 (written plan document requirement); IRS Notice 2022-41 (permitted election changes); Department of Labor Form 5500 filing requirements; S.C. Code §12-6-510.

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