What Is a Section 125 Plan and How Does It Work?

A Section 125 plan, often called a cafeteria plan, is an employer-sponsored arrangement that lets you pay for health insurance premiums, out-of-pocket medical costs, dependent care, and a few other qualified benefits with pre-tax dollars. You sign a salary reduction agreement, your gross pay drops by the amount you elect, and that money goes to your chosen benefits before federal income tax, Social Security, and Medicare are calculated. The savings show up on every paycheck, and for 2026 the contribution ceilings on the two most-used accounts are higher than they have ever been.

How the Pre-Tax Mechanism Works

The salary reduction is the whole engine. You agree to lower your gross pay by a set amount each pay period, and that money is directed into your chosen benefit accounts or toward your share of insurance premiums. Because the reduction happens before taxes are calculated, you never pay federal income tax, Social Security tax, or Medicare tax on that money.¹

The FICA piece is where the arithmetic gets interesting. The employee share of FICA is 7.65% of wages: 6.2% for Social Security and 1.45% for Medicare.² Every dollar you route through the cafeteria plan avoids that 7.65%, and your employer avoids a matching 7.65% on the same wages. A $3,400 health FSA contribution saves both you and your employer roughly $260 each in FICA alone, before any income tax savings.

A concrete example. An employee earning $60,000 who directs $3,400 to a health FSA and $3,000 to insurance premiums shelters $6,400 from tax. At a combined federal-plus-state marginal rate of about 30%, that is roughly $1,920 in income tax savings, plus another $490 in FICA. The money was already going to those expenses, so the tax benefit is pure upside.

Most states follow the federal treatment and exclude cafeteria plan contributions from state income tax. A small number do not, and in those states your salary reduction contributions still count as taxable income at the state level. Your federal income tax and FICA savings stay intact either way, and payroll should handle the different withholding automatically.

Benefits You Can Fund Through the Plan

The Internal Revenue Code limits cafeteria plans to a specific list of qualified benefits that already receive favorable treatment elsewhere in the code.³ Not every workplace perk fits.

Premium Only Plans

The simplest version is a premium only plan, which lets you pay your share of employer-sponsored medical, dental, and vision premiums with pre-tax dollars. Many employers that offer group health insurance but nothing else still run a premium only plan because it is easy to administer and saves both sides money on every check.

Health Flexible Spending Accounts

A health FSA sets aside pre-tax money for out-of-pocket medical costs: copays, deductibles, prescriptions, eyeglasses, and a wide range of other eligible expenses. The full annual election is available on the first day of the plan year even though payroll deductions come out gradually. That front-loading is the health FSA’s biggest practical advantage over paying out of pocket.

Dependent Care Flexible Spending Accounts

A dependent care FSA covers care for a qualifying child under 13 or a disabled dependent, provided the care lets you and your spouse work or look for work.⁴ Eligible expenses include daycare, preschool, before- and after-school programs, and adult day care for a disabled dependent. Summer day camp counts; overnight camp does not. Unlike a health FSA, the account is not front-loaded: you can only be reimbursed up to what you have contributed so far.

HSA Contributions Through Payroll

A health savings account is not itself a cafeteria plan benefit, but the two can be wired together. If you are enrolled in a qualifying high-deductible health plan, your employer can route your HSA contributions through pre-tax payroll deductions using the Section 125 plan. The advantage over contributing on your own and claiming the deduction at tax time is that the payroll route also avoids FICA, which the above-the-line deduction does not recapture. That adds about 7.65% to your savings on the same contribution.

Group Term Life and Adoption Assistance

Group term life insurance can be offered through the plan, but only the first $50,000 of employer-provided coverage is fully tax-free. Coverage above $50,000 creates imputed income subject to Social Security and Medicare tax, even inside the cafeteria plan.⁵ Adoption assistance can also run through the plan, but with unusual tax mechanics: it is exempt from federal income tax but still subject to FICA.¹

What Doesn’t Qualify

Long-term care insurance is explicitly excluded from Section 125 plans. Educational assistance and tuition reimbursement are also ineligible, even though they get favorable treatment under other code sections. The statute specifically carves out benefits under Sections 117 (scholarships), 127 (educational assistance), and 132 (certain fringe benefits) from the definition of qualified cafeteria plan benefits.³

2026 Contribution Limits

Dollar limits adjust annually for inflation, and 2026 brings increases across the board:

Health FSA: $3,400 maximum employee salary reduction, up from $3,300 in 2025.⁶
Health FSA carryover: up to $680 in unused funds can roll into the next plan year if the employer’s plan allows carryovers, up from $660 in 2025.
Dependent care FSA: $7,500 per household, or $3,750 if married filing separately.⁷
Group term life insurance: the first $50,000 of coverage is tax-free. This threshold is fixed by statute and does not adjust for inflation.⁵

The DCFSA number is the story here. The dependent care limit sat at a flat $5,000 for decades. Congress raised it to $7,500 effective for tax years beginning after December 31, 2025, which is a real jump in tax savings for families with childcare costs.

Enrollment and Mid-Year Changes

You pick your benefits during your employer’s annual open enrollment, usually a few weeks before the plan year starts. Once you elect, your choices are locked in for the full 12 months. That irrevocability is core to how cafeteria plans keep their tax-favored status.³

The IRS does allow mid-year changes for qualifying life events, but only if your employer’s plan document permits changes for the specific event. Common ones include:

Marriage or divorce: add or drop a spouse’s coverage.
Birth or adoption: add the child and increase FSA elections.
Change in employment status: you or your spouse starts or loses a job.
Loss of other coverage: your spouse’s employer drops health coverage, so you enroll in or expand your own.

The change has to be consistent with the event. Losing your spouse’s dental coverage does not let you drop your own medical plan. Most employers require the request within 30 days of the event, though some events tied to Medicaid or CHIP eligibility carry a 60-day window. Miss the deadline and you wait for the next open enrollment.

Use-It-or-Lose-It, Grace Periods, and Carryovers

Health FSAs and dependent care FSAs operate on a strict use-it-or-lose-it basis. Money left in the account at the end of the plan year is forfeited back to the employer.⁸ This is the single biggest risk of participating, and the reason people tend to under-elect rather than risk forfeiture.

To soften the blow, the IRS lets employers offer one of two relief options, but not both:⁹

Grace period: an extra two and a half months after the plan year ends to incur new eligible expenses using last year’s remaining balance. For a calendar-year plan, that runs through March 15.
Carryover: up to $680 (for 2026) of unused health FSA funds rolls automatically into the next plan year. Anything above $680 is still forfeited, and the carryover does not reduce how much you can elect for the new year.

Your employer picks one, the other, or neither. Don’t confuse either with a run-out period, which is separate: a run-out period gives you extra time (typically 90 days) to submit claims for expenses you already incurred during the plan year.¹⁰ A grace period lets you incur new expenses. Many plans offer a run-out period plus either a grace period or carryover.

What Happens When You Leave Your Job

This is where participants most often get caught off guard. When you leave, your salary reduction contributions stop and your FSA participation generally ends on your termination date. For a health FSA, you can only submit claims for expenses incurred before your last day. Any remaining balance is forfeited.

There is one useful asymmetry. If you have already spent more from your health FSA than you have contributed so far, you keep the benefit and your employer cannot claw it back. Because the full annual election is available from day one, an employee who elected $3,400 but leaves in March after contributing only $850 in payroll deductions can still submit claims up to $3,400 for expenses incurred before termination. If the employee has already been reimbursed $2,000, the employer absorbs the $1,150 shortfall.

COBRA continuation can apply to health FSAs, but it rarely makes financial sense. An employer only has to offer COBRA for a health FSA if the account is “overspent” at the qualifying event, meaning you have already been reimbursed more than you have contributed.¹¹ If the account is underspent, COBRA generally is not required. Even when offered, electing COBRA means paying the full contribution plus a 2% administrative fee without any employer payroll pre-tax advantage, so the tax benefit largely disappears.

Dependent care FSAs work differently. Reimbursement is capped by what you have actually contributed, so there is no overspent scenario. You can still submit claims for expenses incurred during the period your contributions covered.

1
Internal Revenue Service. FAQs for Government Entities Regarding Cafeteria Plans
2
Social Security Administration. SI 00820.102 Cafeteria Benefit Plans
3
Office of the Law Revision Counsel. 26 USC 125 Cafeteria Plans
4
Internal Revenue Service. Child and Dependent Care Credit Information
5
Internal Revenue Service. Group-Term Life Insurance
6
FSAFEDS. Message Board – 2026 HCFSA Contribution Limit
7
Office of the Law Revision Counsel. 26 USC 129 Dependent Care Assistance Programs
8
Internal Revenue Service. Publication 969 (2025), Health Savings Accounts and Other Tax-Favored Health Plans
9
Internal Revenue Service. IRS – Eligible Employees Can Use Tax-Free Dollars for Medical Expenses
10
Internal Revenue Service. Section 125 – Cafeteria Plans – Modification of Application of Rule Prohibiting Deferred Compensation
11
U.S. Department of Labor. FAQs on COBRA Continuation Health Coverage for Workers