Section 125 Plan

Example

“Maria saved $2,400 in taxes last year by participating in her employer's Section 125 plan, using pre-tax dollars to pay for her health insurance premiums and child care expenses.”

Memory Tip

Remember 'Section 125 = I-2-5ave' (I want to save) - this plan helps you save money on taxes by paying for benefits before taxes are calculated.

Why It Matters

Section 125 plans can save employees thousands of dollars annually in federal, state, and Social Security taxes by reducing their taxable income. For someone in the 22% tax bracket, every $1,000 in pre-tax benefits saves approximately $300 in taxes.

Common Misconception

Some people think all employee benefits automatically come out pre-tax, but you must actively elect to participate in a Section 125 plan during open enrollment. Others believe you can change your elections anytime, when changes are only allowed during specific periods or qualifying life events.

In Practice

An employee earning $60,000 annually elects $4,800 in health insurance premiums and $2,400 in dependent care through their Section 125 plan. This reduces their taxable income to $52,800, saving them approximately $2,196 in federal taxes (22% bracket), $550 in FICA taxes (7.65%), and additional state taxes. Instead of paying $7,200 in after-tax dollars for these benefits, they effectively pay only $4,454 after tax savings, keeping an extra $2,746 in their pocket each year.

Etymology

Named after Section 125 of the Internal Revenue Code, which was added in 1978 to allow employees to choose between taxable and non-taxable benefits without creating constructive receipt issues.

Common Misspellings

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