How to Set Up a Section 125 Plan and Stay Compliant

To set up a Section 125 plan, an employer adopts a written plan document before the plan year begins, decides which qualified benefits the plan will offer, runs a prospective open enrollment where employees sign salary reduction agreements, and commits to annual nondiscrimination testing (or elects the small-employer safe harbor that skips it). The plan lets employees choose between taxable cash and pre-tax qualified benefits like health insurance premiums, flexible spending accounts, and dependent care assistance. Miss any of those setup steps and the IRS can treat the arrangement as if it never existed, which means every “pre-tax” dollar gets reclassified as taxable wages.¹

Confirm You Can Sponsor One

Any employer with at least one common-law employee can establish a Section 125 cafeteria plan. The plan must be maintained by an employer, and every participant must be an employee.²

That “employee” requirement excludes several people who often assume they’re covered. Sole proprietors, partners in a partnership, and S corporation shareholders who own more than 2% of the company cannot participate.³ S corp owner-employees get tripped up most often because they receive a W-2 and reasonably assume that qualifies them. It doesn’t. If any of these individuals appear on the plan taking pre-tax deductions, the IRS will disallow the tax benefit for them.

Choose Between a POP and a Full Cafeteria Plan

The first design decision is scope. A Premium Only Plan, usually called a POP, does one thing: it lets employees pay their share of group health, dental, and vision premiums with pre-tax dollars through salary reduction. It’s inexpensive to establish and easy to run. If pre-tax premiums are all you need, stop here.

A full cafeteria plan adds one or more flexible spending arrangements on top. A Health Care FSA lets employees set aside pre-tax money for eligible out-of-pocket medical expenses. A Dependent Care FSA covers childcare or care for a dependent who can’t care for themselves, provided the care enables the employee to work.⁴ FSAs bring more paperwork because of use-it-or-lose-it rules and separate nondiscrimination requirements, but they meaningfully expand the tax savings employees can capture.

Decide Which Qualified Benefits to Offer

Only benefits that qualify under Section 125 can flow through the plan. The statute defines a qualified benefit as one excludable from gross income under a specific provision of the tax code, with some carve-outs.⁵ The common menu:

Group accident and health coverage, including medical, dental, and vision premiums
Health FSA contributions for eligible medical expenses not covered by insurance
Dependent Care FSA contributions for qualifying dependent care
HSA contributions by salary reduction for employees enrolled in a qualifying high-deductible health plan
Group term life insurance that qualifies for the income exclusion under Section 79

A few things you might expect to see on that list aren’t allowed. Long-term care insurance is specifically excluded, even though it looks like a natural fit. Archer MSAs, educational assistance programs, and qualified health plans purchased through an ACA marketplace exchange are also out.²

2026 Contribution Limits

Several limits adjust for inflation. For the 2026 plan year:

Health FSA salary reduction limit: $3,400 per employee
Health FSA carryover maximum: $680, if the plan permits carryover
Dependent Care FSA limit: $7,500 per household for joint filers or single/head-of-household filers, or $3,750 for married individuals filing separately⁴

If you’re including a Health FSA, decide during setup how you’ll handle unused funds. Money left at year-end is otherwise forfeited. You have two relief options, and you can pick only one. A grace period gives employees an extra two and a half months after the plan year ends to incur eligible expenses. A carryover provision rolls up to $680 of unused Health FSA funds into the next plan year.⁶ The IRS made them mutually exclusive when it introduced the carryover.⁷ Neither is required, but offering neither guarantees frustration and lower participation.

Draft and Adopt the Written Plan Document

A Section 125 plan does not legally exist until the employer adopts a formal written plan document. This is not a technicality. If pre-tax deductions start coming out of paychecks without an executed plan document already in place, the IRS can treat the plan as nonexistent and demand back taxes on every dollar deducted.¹

Timing is strict. The document must be adopted on or before the first day of the plan year it covers. Backdating doesn’t work. Adoptions and amendments must be prospective.

At a minimum, the document has to describe the benefits offered, establish eligibility rules, and lay out election procedures.² In practice that means:

Descriptions of each qualified benefit available, including any FSA or DCAP components
Eligibility and participation rules, keeping in mind that no more than three years of service can be required as a condition of participation¹
Election procedures, including the open enrollment window and how employees make selections
Maximum contribution amounts for each benefit component
The plan year, which is the 12-month period governing elections and testing (calendar year is common, but a fiscal year aligned with insurance renewals also works)
FSA forfeiture rules, spelling out use-it-or-lose-it and whether a grace period or carryover applies

Many employers use a pre-drafted master plan document paired with an adoption agreement. The master document holds the standardized legal language; the adoption agreement captures the employer’s specific choices about benefits offered, eligibility waiting period, plan year dates, and similar details. The adoption agreement alone is not a substitute for the full plan document.

Summary Plan Description

Separate from the legal document, the employer must prepare and distribute a Summary Plan Description to all eligible employees. The SPD translates the plan’s legal language into terms employees can understand: who is eligible, how to enroll, what benefits are available, the claims process, and the rules for changing elections mid-year. Include the plan administrator’s name and contact information.

Amendments

Any change to the plan design requires a formal written amendment. Amendments, like the original document, have to be adopted prospectively. You cannot retroactively amend a Section 125 plan to cover a change that already took effect, with very narrow exceptions.⁸ Letting the document fall out of date puts the whole plan’s tax-advantaged status at risk.

Run Enrollment and Collect Salary Reduction Agreements

Once the document is signed, the employer holds an open enrollment period before the plan year begins. Every eligible employee needs enough information to choose between taxable cash and pre-tax benefits: what’s available, the contribution limits, the use-it-or-lose-it rule if FSAs are on the menu, and the fact that elections lock in for the full plan year.

Each participating employee signs a salary reduction agreement authorizing the employer to redirect part of their gross pay toward the elected benefits on a pre-tax basis. The agreement must be executed before the compensation it applies to is earned and available. This prospective timing is what makes the arrangement work: because the employee commits to the reduction before earning the money, the reduced amount is never treated as constructive receipt of taxable income.¹

Electronic enrollment and electronic signatures are fine, as long as the system meets the requirements of the federal E-SIGN Act as reflected in Treasury regulations. The system has to be able to create a record of the election that the participant can access and retain.⁹ For employees who decline to participate, collect a written waiver for your records. The tax code doesn’t strictly require it, but it saves arguments later.

Set the Rules for Mid-Year Election Changes

Elections are irrevocable for the plan year with limited exceptions. An employee can change an election mid-year only if they experience a qualifying change-in-status event and the requested change is consistent with that event.¹⁰ The recognized events include:

Marriage or divorce
Birth or adoption of a child
A change in the employee’s employment status, or that of a spouse or dependent, that affects benefit eligibility¹¹
A change in a dependent’s eligibility, for example a child aging out of coverage

The consistency requirement is the piece employers miss. If an employee gets married, they can add a new spouse to health coverage, but they can’t use the marriage as a reason to drop their own FSA election. Each change has to logically follow from the event. IRS regulations give employers some discretion over which qualifying events to permit, so spell out in the plan document exactly which ones your plan will recognize.

Plan for Nondiscrimination Testing

Section 125 plans must pass annual nondiscrimination testing so the tax benefits aren’t concentrated among highly compensated and key employees. A failure doesn’t blow up the whole plan, but it does strip the tax-free treatment from the highly compensated and key employees for that year while everyone else keeps theirs.¹²

Three tests apply:

The eligibility test, which examines whether enough non-highly-compensated employees can participate. Service requirements are capped at three years, and eligible employees must be able to begin participation no later than the first day of the plan year after they meet the service requirement.¹
The contributions and benefits test, which asks whether non-highly-compensated employees receive benefits and contribution opportunities comparable to those available to highly compensated employees. A plan offering a uniform set of benefits to all eligible participants generally passes.
The key employee concentration test, which caps the total nontaxable benefits provided to key employees at 25% of the aggregate nontaxable benefits under the plan.¹²

For testing, a highly compensated employee is someone who earned more than $160,000 from the employer during the prior plan year, or who owned more than 5% of the business at any point during the current or prior plan year.¹³ A key employee is an officer with annual compensation above $235,000, a more-than-5% owner, or a more-than-1% owner earning over $150,000.

Run testing early enough in the plan year to correct course if a failure looks likely. Waiting until year-end means the highly compensated participants owe taxes on benefits they’ve already received, and the employer may owe its share of payroll taxes on those amounts.

Simple Cafeteria Plan Safe Harbor

Employers with 100 or fewer employees who received at least $5,000 in compensation during the prior year have an easier path. Section 125(j) creates a “simple cafeteria plan” that is automatically treated as satisfying all three nondiscrimination tests, plus the nondiscrimination rules for group term life insurance, self-insured medical reimbursement plans, and dependent care assistance programs.¹ For a small employer who doesn’t want annual testing, this is worth serious consideration.

Two conditions apply. First, all employees with at least 1,000 hours of service in the prior plan year must be eligible to participate. Second, the employer has to make a minimum contribution for each eligible non-highly-compensated employee, using one of two formulas:

A nonelective contribution of at least 2% of each employee’s compensation, regardless of whether the employee makes any salary reduction election
A dollar-for-dollar match of each employee’s salary reduction, up to 6% of compensation, or, if less, twice the employee’s actual salary reduction amount⁵

Once established, a simple cafeteria plan stays eligible even if headcount grows, as long as the average doesn’t reach 200 employees. The matching rate for highly compensated and key employees can’t be more generous than the rate offered to other employees.

What Goes Wrong When Setup Is Skipped

The consequences of a defective plan fall on both sides of the payroll. If the IRS decides the plan doesn’t meet statutory requirements, whether because there’s no written document, elections weren’t prospective, or nondiscrimination testing was never run, the agency can treat the plan as if it never existed. Every dollar that flowed through as a “pre-tax” deduction gets reclassified as taxable wages. Employees owe income tax on those amounts, and both the employer and employees owe the Social Security and Medicare taxes that should have been withheld all along. The employer also faces penalties for failing to withhold and report correctly.

Three mistakes cause most of these failures: operating without a signed plan document, letting employees change elections outside of qualifying events, and ignoring nondiscrimination testing entirely. All three are preventable with a proper setup and a basic annual compliance calendar built around the plan year.

1
Office of the Law Revision Counsel. 26 U.S. Code 125 – Cafeteria Plans
2
Internal Revenue Service. FAQs for Government Entities Regarding Cafeteria Plans
3
Internal Revenue Service. S Corporation Compensation and Medical Insurance Issues
4
Office of the Law Revision Counsel. 26 U.S. Code 129 – Dependent Care Assistance Programs
5
Office of the Law Revision Counsel. 26 USC 125 – Cafeteria Plans
6
Internal Revenue Service. Eligible Employees Can Use Tax-Free Dollars for Medical Expenses
7
Internal Revenue Service. IRS Notice 2020-33 – Modification of Permissive Carryover Rule
8
Internal Revenue Service. IRS Notice 2005-42 – Modification of Application of Rule Prohibiting Deferred Compensation Under a Section 125 Cafeteria Plan
9
eCFR. 26 CFR 1.401(a)-21 – Rules Relating to the Use of an Electronic Medium
10
eCFR. 26 CFR 1.125-4 – Permitted Election Changes
11
Internal Revenue Service. TD 8878 – Tax Treatment of Cafeteria Plans
12
Office of the Law Revision Counsel. 26 USC 125 – Cafeteria Plans
13
Internal Revenue Service. Identifying Highly Compensated Employees in an Initial or Short Plan Year