Section 125 Plan Rules and Regulations (2026 Guide)

Reviewed by a licensed benefits professional. Last reviewed: October 14, 2026.

Section 125 plan rules and regulations come from one law, Section 125 of the Internal Revenue Code, and a set of Treasury regulations that explain it. Break the rules and the tax savings disappear for the employees the rule was meant to protect. This guide lists each rule in plain English, gives the 2026 limits, and works through one testing example with real arithmetic.

Key facts (2026):

• A cafeteria plan must be a written plan, open only to employees, that lets them choose between cash and qualified benefits (26 U.S.C. 125(d)(1), 2026).
• A plan loses its tax exclusion when key employees receive more than 25% of the total benefits (26 U.S.C. 125(b)(2), 2026).
• For 2026, a key employee is an officer earning over $235,000, a 5% owner, or a 1% owner earning over $150,000 (IRS Publication 15-B, 2026).
• The 2026 health FSA limit is $3,400, and the dependent care limit is $7,500, or $3,750 if married filing separately (IRS Publication 15-B, 2026).
• Employers with 100 or fewer employees can use a simple cafeteria plan to meet the nondiscrimination rules (26 U.S.C. 125(j), 2026).

What Are the Section 125 Plan Rules and Regulations?

Section 125 plan rules require a written plan, employee-only participation, a choice between cash and qualified benefits, no deferred pay, nondiscrimination, and set election timing. A Section 125 plan, also called a cafeteria plan, is a written employer plan that lets employees pay for benefits before taxes.

The table lists each core rule and where it comes from. Our Section 125 cafeteria plan guide explains how the plan works day to day.

Table: The core Section 125 rules

Who Can Participate in a Section 125 Plan?

Only employees can participate in a Section 125 plan. Present and former employees qualify, but self-employed individuals do not, which excludes sole proprietors, partners and 2% or greater S corporation shareholders, per IRS cafeteria plan training.

The plan also cannot be set up mainly for former employees, and only the participant can make elections, though beneficiaries can receive the benefits. An employer can require up to three years of service before someone joins, if the rule applies to everyone equally (26 U.S.C. 125(g)(3), 2026). Owners who cannot join are a common trap, and our guides to S corporation shareholders and LLC members and partners cover the details.

What Benefits Can a Section 125 Plan Offer?

A Section 125 plan can offer health coverage, dependent care assistance, group-term life insurance, adoption assistance and HSA contributions. It cannot offer long-term care insurance or any benefit that defers pay, other than a 401(k).

The IRS defines a qualified benefit as one that does not defer compensation and is excluded from income under a specific Code section. Our zero-cost employee benefits guide shows which of these cost the employer nothing to add.

Table: What a Section 125 plan can and cannot include

What Are the Section 125 Nondiscrimination Rules?

Section 125 nondiscrimination rules stop a plan from favoring highly compensated employees or key employees, and a failed test can make benefits taxable for the favored group. The tests look at who can join, who gets which benefits, and how much goes to key employees.

The statute sets the main tests in 26 U.S.C. 125(b). The exclusion is lost for a plan year in which the plan discriminates in favor of highly compensated individuals on eligibility, or highly compensated participants on contributions and benefits. It is also lost when qualified benefits to key employees exceed 25% of the total.

Two relief paths exist. A health safe harbor applies if employer contributions equal 100% of the cost for most similarly situated highly compensated participants, or at least 75% of the cost of the highest-cost coverage (26 U.S.C. 125(g)(2), 2026). Employers with an average of 100 or fewer employees can adopt a simple cafeteria plan with a required employer contribution (26 U.S.C. 125(j), 2026).

Worked example: the 25% key employee test

This example is hypothetical. A company's plan provides $120,000 in nontaxable benefits for the year. Key employees, meaning owners and officers who meet the 2026 definition, receive $33,000 of that total. The test is key employee benefits divided by total benefits.

The plan fails by $3,000, or 2.5 percentage points. The fix is to reduce key employee benefits to $30,000 or less, or raise the benefits other employees use. Our nondiscrimination testing guide and key employee definition walk through the full test.

When Do Employees Have to Make Section 125 Elections?

Employees must make Section 125 elections before the plan year begins, and those elections generally stay locked for the full plan year. IRS cafeteria plan training says participants must elect benefit types and amounts before the plan year starts.

An election generally cannot cover less than 12 months, but new employees may elect coverage for part of a plan year, per the same IRS training. Employees who miss the window wait for the next one. See our guides on the Section 125 plan year and annual re-enrollment and evergreen elections for how elections roll from one year to the next.

When Can an Employee Change a Section 125 Election Mid-Year?

An employee can change a Section 125 election mid-year only after an event listed in 26 CFR 1.125-4, and only if the plan chooses to allow it. The regulation says Section 125 does not require a plan to permit any of these changes.

The change must also fit the event. For health coverage, a change must be "on account of and corresponds with a change in status that affects eligibility for coverage," under 1.125-4(c)(3). A divorce, for example, lets an employee drop the former spouse but not other dependents.

Table: Common permitted election change events

Our qualifying events hub lists the IRS rules for each event with examples.

What Does a Section 125 Plan Document Need to Say?

A Section 125 plan document must describe each benefit, name eligible employees, set election rules, explain employer contributions, state the maximum contribution, and state the plan year. IRS cafeteria plan training lists all six items.

1. Benefits. Each benefit offered and its coverage period.
2. Eligibility. Which employees can participate.
3. Election procedures. When elections are made, when they are irrevocable, and how long they last.
4. Employer contributions. Whether they come from salary reduction, employer funds, or both.
5. Maximum contribution. The most any participant can receive, by dollar amount, percentage or method.
6. Plan year. The 12-month period the plan uses.

The document must exist in writing, because 26 U.S.C. 125(d)(1) defines a cafeteria plan as a written plan. Our plan document and SPD guide shows what to include in the summary plan description.

What Happens if a Plan Breaks the Section 125 Rules?

A plan that breaks Section 125 rules loses the tax exclusion, so the affected benefits become taxable wages. A plan that provides deferred compensation is not a cafeteria plan at all (26 U.S.C. 125(d)(2)(A), 2026).

The consequences depend on the rule. A failed nondiscrimination test affects the favored employees. A plan with no written document is not a cafeteria plan at all, because 26 U.S.C. 125(d)(1) requires one. Employers who find a problem should fix it for the current plan year and document the fix. Our guides to Section 125 penalties and eligibility requirements cover the common failures.

How Much Does a Compliant Section 125 Plan Save?

A compliant Section 125 plan saves employers 7.65% in FICA on every pre-tax dollar employees contribute. Employees save the same 7.65% plus their income tax. FICA is 6.2% Social Security plus 1.45% Medicare, and the 2026 Social Security wage base is $184,500 (IRS Publication 15, 2026).

This example is hypothetical. A company has 10 enrolled employees who each put $1,500 a month of pre-tax benefit dollars, such as premiums and FSA contributions, into the plan. Summit Health Benefits charges $35 per enrolled employee per month, paid from the FICA savings.

Summit Health Benefits' published range is a net employer benefit of about $56 to $101 per enrolled employee per month after the fee, so this example sits inside it. The fee comes out of the savings, so the employer does not pay it from operating cash. Our FICA tax savings guide shows the formula in full.

Should You Run a Section 125 Plan Yourself or Use an Administrator?

An administrator handles the written plan, the election window and the testing so the plan keeps passing the rules. Doing it yourself works for very small plans if someone owns the calendar. Most employers miss a deadline or skip a test.

Summit Health Benefits provides a written plan document, a summary plan description and nondiscrimination testing support, with documents reviewed by ERISA attorneys. Summit Health Benefits charges $35 per enrolled employee per month, paid from the FICA savings the plan creates, so the employer still nets about $56 to $101 per enrolled employee per month. Use the Summit savings calculator to model your own numbers, or read the complete Section 125 plan guide for the full picture.

Free copy-paste Section 125 compliance checklist

1. Written plan document signed and effective on or before the first day of the plan year.

2. Summary plan description given to participants.

3. Plan year stated in the document.

4. Only employees enrolled, with no sole proprietors, partners or 2% S corporation owners.

5. Only qualified benefits offered, with no long-term care insurance.

6. Elections collected before the plan year begins.

7. Election change events and the plan's own change rules written down.

8. Eligibility, contributions and benefits, and 25% key employee tests run each plan year.

9. Health FSA capped at $3,400 and dependent care capped at $7,500 for 2026.

10. Test results and election records saved for the year.

Frequently Asked Questions

Sources

26 U.S.C. 125, Cafeteria plans (2026, Cornell Legal Information Institute); 26 CFR 1.125-4, Permitted election changes (2026, Cornell Legal Information Institute); IRS Publication 15-B, Employer's Tax Guide to Fringe Benefits (2026); IRS Publication 15, Employer's Tax Guide (2026); IRS cafeteria plan training, Lesson 4 (IRS.gov); Summit Health Benefits plan terms, $35 per enrolled employee per month (2026).