Section 125 Tax Code: Pre-Tax Deductions, Elections, and Trade-Offs

Section 125 of the tax code is the provision that lets your employer set up a “cafeteria plan,” an arrangement where you pay for health insurance, flexible spending accounts, and certain other benefits with pre-tax dollars. Congress added it in 1978, and the mechanics have been consistent since: money you route through the plan never counts as taxable wages, so you skip federal income tax and FICA on every dollar, and your employer skips its share of payroll tax on the same money.¹

How the Pre-Tax Mechanism Works

When you enroll, you agree to redirect part of your gross pay toward specific benefits before federal income tax and FICA are calculated. The IRS treats those dollars as if you never received them, so they don’t appear on your W-2 as taxable wages.² You avoid the 6.2% Social Security tax, the 1.45% Medicare tax, and your regular federal income tax rate on the amount routed through the plan.

The savings add up. Someone in the 22% federal bracket who puts $3,400 into a health FSA avoids roughly $1,010 in combined taxes on that contribution alone. Add health premiums and dependent care and the annual savings can easily reach several thousand dollars. Most states follow the federal treatment and exclude these contributions from state income tax, though a few, including New Jersey, do not.³

What Benefits Qualify

Only benefits that are already excluded from income somewhere else in the tax code can run through a Section 125 plan.⁴ In practice, that means:

Medical, dental, and vision premiums for employer-sponsored group coverage. These are the most common cafeteria plan deductions.
Health FSAs, capped at $3,400 for 2026, usable for copays, prescriptions, glasses, and other qualifying medical expenses.
Dependent Care FSAs, capped at $5,000 for married-filing-jointly and single filers, for daycare, preschool, and after-school care for children under 13 or a qualifying dependent who can’t care for themselves.
HSAs funded by payroll deduction, capped for 2026 at $4,400 self-only and $8,750 family, available only if you are enrolled in a high-deductible health plan with a deductible of at least $1,700 self-only or $3,400 family.⁵
Group term life insurance up to $50,000 in coverage.
Adoption assistance benefits.

Long-term care insurance cannot go through a cafeteria plan, and neither can individual health coverage bought on the ACA marketplace, aside from a narrow small-employer exception.⁴

Enrolling and When Your Choices Lock In

You enroll during an open enrollment period, usually once a year before the next plan year starts. The IRS requires elections to be made prospectively: you choose your benefits and contribution amounts before the plan year begins, not after.⁶ Once the plan year is underway, payroll adjusts each check to reflect the pre-tax deductions you selected.

If you’re a new hire joining mid-year, your employer gives you an enrollment window, and any election takes effect from your enrollment date forward, not retroactively to the start of the plan year. One exception: if you enroll within 30 days of a birth, adoption, or placement for adoption, coverage can be applied retroactively to the date of that event.⁷

Keep your enrollment confirmation. If there’s ever a dispute about what you chose, that’s your proof. Think hard about the FSA amount in particular. Once the plan year begins, you’re generally stuck with it, and anything left over is at risk of forfeiture.

Changing Your Elections Mid-Year

Cafeteria plan elections are irrevocable for the plan year, with limited exceptions. Treasury regulations spell out the specific events that let you change mid-year:⁸

A change in marital status: marriage, divorce, legal separation, annulment, or death of a spouse.
A change in the number of dependents: birth, adoption, placement for adoption, or death of a dependent.
A change in employment status for you, your spouse, or your dependent that affects benefit eligibility, including starting or stopping work, an unpaid leave, or a work location change.
Loss of other coverage, such as your spouse losing employer-sponsored insurance.

You usually have 30 days to request the change, though some plans allow up to 60 days for certain events. The new election has to be consistent with the event. You can’t use a marriage as a reason to drop dental coverage that has nothing to do with your new spouse’s benefits, and your employer must deny any request that doesn’t fit the rules, because allowing it would jeopardize the plan’s tax-favored status for everyone in it.⁸ Bring documentation: a marriage certificate, birth record, or a letter from a former employer confirming loss of coverage. Miss the window and you wait until the next open enrollment, even if the qualifying event was legitimate.

Use-It-or-Lose-It and How Employers Soften It

The default rule for health FSAs is that any money left in your account when the plan year ends disappears. Employers can offer one of two forms of relief, but not both at once.

The first is a grace period. If your plan has one, you get an extra two and a half months after the plan year ends to spend down your balance on eligible expenses. For a calendar-year plan, that runs through March 15. The grace period must apply to everyone in the plan, and the leftover money can only be used for the same type of benefit; unused medical FSA dollars can’t be shifted to cover dependent care.⁹ Anything still unspent after the grace period is forfeited.

The second is a carryover. Plans that use this option let you roll up to $680 of unused health FSA money into the next plan year (the 2026 limit). The carryover doesn’t count against the new year’s contribution limit, so you can still put in the full $3,400 on top of it. This is more forgiving if you tend to overestimate your medical spending.

HSAs work differently. Balances roll over indefinitely, the account is yours permanently, and that’s part of why HSAs have become more popular. If your employer offers both an HSA-eligible high-deductible plan and a traditional plan with an FSA, the rollover difference alone is worth weighing.

The Social Security Trade-Off

One downside of pre-tax cafeteria plan contributions rarely comes up during open enrollment. Because the money bypasses Social Security and Medicare taxes, it also reduces your Social Security earnings record. The Social Security Administration confirms that amounts contributed through a salary reduction agreement under Section 125 are not subject to Social Security, Medicare, or income taxes and are not counted as wages for benefit calculation purposes.¹⁰

For most people the effect is small. A single $3,400 FSA contribution barely registers over a 35-year career. Over decades of large pre-tax contributions, though, especially for someone near one of the Social Security benefit formula breakpoints, the cumulative reduction in lifetime earnings could modestly lower the eventual retirement benefit. The immediate tax savings almost always outweigh it, but the trade-off is real.

Read Your Plan Document

Every cafeteria plan has to exist as a formal written document. The statute defines a cafeteria plan as a written plan, and the IRS requires it to describe the available benefits, eligibility rules, and election procedures.² You should also receive a Summary Plan Description that translates it into plain English.¹¹

The SPD is where you find out whether your plan uses the grace period or the carryover, which qualifying events trigger mid-year changes, and whether administrative fees come out of your account. Most people skip it and then get surprised in February when an unused FSA balance vanishes. Ten minutes with the document before you set your contribution is worth more than the tax break itself if it keeps you from forfeiting money at year-end.

1
Office of the Law Revision Counsel. 26 USC 125 – Cafeteria Plans
2
Internal Revenue Service. FAQs for Government Entities Regarding Cafeteria Plans
3
State of New Jersey Department of the Treasury. Technical Bulletin 39R – Cafeteria Plans
4
Office of the Law Revision Counsel. 26 US Code 125 – Cafeteria Plans
5
Internal Revenue Service. Revenue Procedure 2025-19
6
Internal Revenue Service. Introduction to Cafeteria Plans
7
Internal Revenue Service. Tax Treatment of Cafeteria Plans
8
eCFR. 26 CFR 1.125-4 – Permitted Election Changes
9
Internal Revenue Service. Notice 2005-42 – Modification of Application of Rule Prohibiting Deferred Compensation Under a Section 125 Cafeteria Plan
10
Social Security Administration. POMS SI 00820.102 – Cafeteria Benefit Plans
11
Internal Revenue Service. 401(k) Resource Guide Plan Participants Summary Plan Description