What is Section 125 Premium Only Plan & How it Works

Businesses and organizations constantly look for ways to improve employer-sponsored benefits while keeping costs low and satisfaction high. The section 125 premium only plan often called a POP does exactly that.

It allows organizations to have employees pay for health insurance premiums through pre-tax payroll deduction, reducing their taxable income yet requiring no extra effort from the employer.

This is such a simple yet powerful plan option that originates from internal revenue code section 125 and functions as a type of cafeteria plan.

1.0 What is a section 125 plan?

A section 125 plan is a written agreement that permits employees to select between cash wages and qualified nontaxable benefits. The IRS requires that such a benefit plan offer at least one taxable element and one qualified benefit, the selection itself is meant to avoid creating taxable income for that contribution. The employer manages such a plan separately from regular payroll functions.

1.1 What is a section 125 premium plan (POP)?

The premium only plan exists as the most basic form of a cafeteria plan. The pre-tax payroll deduction applies only to health insurance premiums, medical, dental or vision coverage. No other benefits are offered within such a plan. This maintains administrative simplicity while providing real tax relief.

1.2 How does the IRS define a section 125 plan?

The IRS defines a section 125 plan as a separate and written plan establishing a choice between cash-based and qualified benefits within the plan. Contributions lead to a reduction in federal income tax withholding and generally to avoidance of FICA taxes (for Social Security and Medicare) as well as Medicare Tax. The plan must follow applicable rules and documentation procedures to retain this tax-advantage status.

2.0 How does a section 125 premium only plan work?

A section 125 premium only plan changes who pays for health insurance premiums to pre-tax dollars. The employee sees tax savings right away, the employer also sees a reduction of their payroll tax burden. Here's the process:

1. Employees select desired health benefit coverage during open enrollment periods or life events.

2. The chosen amount is taken from gross pay prior to tax calculations.

3. The employer sends that amount directly to the insurance provider.

4. Employees see lower taxable wages on their W-2 form - which then reflects every paycheck.

2.1 How does a POP work in payroll step-by-step?

The payroll system handles these elements exactly:

1. The employee presents a signed election form prior to the plan year begins.

2. Payroll software identifies the elected benefit contribution as pre-tax deduction.

3. Gross pay is reduced before Federal Income Tax Withholding, FICA taxes (Social Security & Medicare) and Medicare tax calculations.

4. Net pay reflects the full pre-tax savings.

5. The employer makes the full premium amount on the employee's behalf with the insurance provider.

To ensure payroll processes and compensation planning remain accurate when applying pre-tax deductions, tools like CompXL® help HR teams manage structured compensation workflows, automate adjustments, and maintain budget control across all pay elements including benefits.

2.2 How does a POP reduce taxable income?

The pre-tax deduction reduces how much wages are submitted to tax authorities. This directly reduces federal income tax withholding as well as the value of wages submitted to FICA taxes (Social Security and Medicare taxes).

A recent economic impact report shows employees in higher tax brackets can save anywhere from 20 to 40 percent or more in combined taxes for every dollar redirected to health insurance premiums.

Tax Type	Without POP	With POP	Savings Impact
Federal Income Tax	Taxed on full wages	Excluded from taxable wages	Lower withholding each pay period
FICA (Social Security & Medicare)	Full 7.65% applied	7.65% avoided on deducted amount	Immediate payroll tax relief
Employee Take-Home Pay	Reduced by taxes	Higher net pay	More money in pocket monthly

To better understand and communicate how these savings affect overall compensation, CompAnalyst® enables organizations to model total pay including benefits, giving HR leaders clear visibility into how programs like POP improve employee take-home pay.

2.3 How do FICA and Medicare taxes change under a POP?

Under the section 125 premium only plan both employee and employer avoid FICA tax (Social Security and Medicare taxes) and Medicare tax on the contributed premiums.

The combined rate of 7.65% (6.2% Social Security plus 1.45% Medicare) applies to every dollar of such pre-tax redirection of funds. Employers with 100 staff members with $3,000 average elections pre-tax each year save thousands of dollars in FICA taxes.

3.0 Who is eligible and what benefits qualify?

The rules regarding eligibility ensure fairness within the benefit program. Only employees may participate - though spouses and dependents may qualify for benefits. The plan cannot favor highly compensated or key company staff members.

3.1 What benefits can be included in a section 125 POP?

A true Premium Only Plan must feature only premium payment benefits. Such benefits may include:

• Medical insurance premiums

• Dental and vision coverage

• Group term life insurance up to $50,000

• Accident or disability insurance premiums

No cash-outs or expense reimbursements are provided within such a plan.

3.2 Who can participate in a section 125 premium only plan?

All who qualify as common law company employees have access. The IRS, however, has specific rules regarding company owners. In general, more than 2% shareholders of an S Corporation, sole proprietors or partnership partners are not eligible to participate under the plan on a tax-favored basis.

These individuals are thought to be self-employed rather than true company employees for tax law purposes. HR departments must ensure such individuals are carefully excluded from pre-tax benefit deductions - otherwise compliance issues may develop during audits.

4.0 Key benefits for employers and employees

Each side sees benefits within such a plan structure. Employees enjoy higher take-home pay while employers see lowered costs overall.

4.1 How does a POP increase employee take-home pay?

Every dollar withheld before taxes goes directly into the employee's bank account. For those in the 22% federal tax bracket, such a $100 deduction each month means roughly $30 more in take-home pay after taxes apply.

4.2 Why do employers offer section 125 premium only plans?

Employers include such a plan element to enhance employer-sponsored benefits, attract talent and lower payroll costs. The employer saves on FICA taxes (Social Security and Medicare) and Medicare taxes. This also helps employee retention all without raising total compensation costs.

5.0 How to set up a section 125 POP and stay compliant

Follow these four essential steps to form and maintain such a plan:

1. Create legal documents: Create both the written plan document and a summary plan description (SPD). These two elements define the plan and its year-long operation. Most companies employ a third-party administrator (TPA) to prepare these elements.

2. Formally adopt the plan: The company must sign a corporate resolution prior to establishing the effective date of the benefits plan. The tax benefits cannot be applied retroactively.

3. Manage payroll and enrollment

   1. Pre-tax deductions: Set up payroll systems to take the health benefits before Federal, State and FICA taxes.

   2. Irrevocable elections: Such employee selections must occur before the start of the tax year. Changes only apply under mid-year "qualifying life" events.

4. Perform annual testing: To preserve tax-free status, the company must pass nondiscrimination testing every year to ensure fairness toward company owners or high earners.

5.1 What documents are required for a POP setup?

The documents that must be formed include:

• A formal written Section 125 plan document

• An adoption agreement made prior to the start of the plan year

• A summary plan description (SPD) should be provided if ERISA applies to the benefits offered

These may be updated and redistributed every five years or following any major plan changes.

5.2 How do employers ensure section 125 compliance?

Employers perform annual nondiscrimination testing (Section 125 Testing) to confirm the benefits do not unfairly favor highly compensated employees. Other elements include maintaining proper election records and filing any relevant ERISA forms.

To strengthen compliance and proactively identify disparities, the Pay Equity Suite helps organizations analyze pay practices, detect imbalances, and support fair benefit distribution aligned with regulatory expectations.

5.3 What compliance risks should HR teams avoid?

Common compliance issues include missing the written plan deadline, failing to conduct nondiscrimination testing (Section 125 Testing) or establishing retroactive elections. All such deductions become taxable under such errors. Regular third-party reviews can help HR teams stay well ahead of these issues.

6.0 FAQs

Here are the common questions about the topic:

6.1. What is a section 125 premium only plan in simple HR terms?

It is a cafeteria plan under internal revenue code section 125 that lets employees pay Health Insurance Premiums with pre-tax dollars through payroll.

6.2. How does a premium only plan reduce employee taxes?

The pre-tax payroll deduction lowers federal income tax withholding, FICA Tax (Social Security & Medicare Taxes), and medicare tax on the elected amount.

6.3. What benefits can be included in a section 125 POP?

Only health insurance premiums for medical, dental, vision, and limited group life coverage qualify.

6.4. Is a section 125 premium only plan mandatory for employers?

No. Employers choose to offer it as an optional enhancement to employer-sponsored benefits.

6.5. What compliance rules should HR be aware of for POP administration?

Key rules cover plan document requirements, annual nondiscrimination testing (Section 125 Testing), and ERISA (Employee Retirement Income Security Act) disclosures when applicable.