What Is a Premium Only Plan? Section 125 Rules and Tax Savings

A Premium Only Plan, or POP, is the simplest form of Section 125 cafeteria plan: it lets employees pay their share of employer-sponsored insurance premiums with pre-tax dollars instead of after-tax dollars, which lowers taxable income for the worker and payroll tax for the employer.¹ Any employer with at least one employee can put one in place. The mechanics are simple. Premiums come out of your paycheck before federal income tax and FICA are calculated, so you never owe tax on that money.

How the Tax Savings Work

Paying premiums pre-tax shrinks the wage figure that federal income tax, most state and local income taxes, and FICA are calculated against. FICA alone is 7.65% of wages: 6.2% for Social Security and 1.45% for Medicare.² If you sit in the 22% federal bracket and your monthly premium is $500, the combined savings run around $148 per month, depending on your state. Total savings typically come in between 25% and 40% of the premium.

The employer saves too. Lower taxable payroll means less matching FICA (another 7.65% on each reduced dollar of wages) and less Federal Unemployment Tax.³ For most employers, that payroll tax savings alone covers the cost of running the plan.

Which Premiums Qualify

A POP covers premiums for employer-sponsored group coverage that counts as a “qualified benefit” under Section 125. The common ones are group health, dental, and vision. Group-term life insurance premiums qualify, but only for the first $50,000 of coverage; anything above that becomes taxable income to the employee.⁴ Accident insurance, specified disease policies, dependent care assistance, and adoption assistance are also eligible.³

Some coverages are off the table. Long-term care insurance cannot be paid pre-tax through a Section 125 plan, and neither can Archer Medical Savings Accounts.³ Individual life insurance policies are also excluded, as is coverage for people who don’t meet the tax code’s definition of your dependents. HSA contributions can flow through a Section 125 plan, but that runs on a separate HSA module rather than the POP itself.

What It Takes to Set One Up

The IRS requires a written plan document for any cafeteria plan, and a POP is no exception.¹ The document acts as the plan’s rulebook. It sets the plan year, lists the eligible premiums, defines who can participate, and describes how employees make elections. Running pre-tax deductions without one is one of the most common employer mistakes, and it can disqualify the arrangement entirely. If that happens, every pre-tax deduction taken during the plan year gets reclassified as taxable wages, and the employer owes back payroll taxes on those amounts.

The POP itself is governed by the tax code rather than ERISA, but the underlying health and welfare plans it funds usually are ERISA-covered. Those underlying plans have their own documentation and disclosure rules, including giving new participants a Summary Plan Description. Keeping the Section 125 document and the ERISA welfare plan documents separate and current is the cleanest approach.

Professional fees to draft a POP plan document and the related materials typically run $150 to $200 as a one-time cost, though some providers charge a recurring per-employee fee. Either way, the employer’s payroll tax savings usually recover the expense inside the first year.

When You Can Change Your Election

Employees make their benefit elections before the plan year starts, and once the year begins the election is locked. This is the irrevocable election rule, and it’s a core feature of every cafeteria plan.⁵ You can’t decide in March to start paying premiums pre-tax if you skipped that choice during open enrollment.

Mid-year changes are allowed only when a specific qualifying event occurs and the plan document permits it. The change also has to be consistent with the event. Losing health coverage and adding a different plan lines up; dropping dental after getting married generally does not.

The qualifying events recognized in the regulations include:⁶

Marriage, divorce, or legal separation.
Birth, adoption, or death of a dependent.
Employment changes, including starting or leaving a job, moving between full-time and part-time, a strike or lockout, or beginning or returning from unpaid leave.
A change in residence or worksite that affects which plans are available.
A dependent losing eligibility, such as a child aging out of coverage.
A spouse’s or dependent’s employment change that shifts their coverage options.

The plan document lists which of these events the employer chooses to recognize. Employers aren’t required to allow all of them. When a qualifying event happens and your plan permits the corresponding change, you generally have 30 days to submit a new election. Miss that window and you’re locked in until the next open enrollment.

Nondiscrimination Testing

Section 125 keeps a POP from becoming a perk that only benefits executives. Three annual tests apply, and failing them doesn’t destroy the plan for rank-and-file employees; it just makes the pre-tax benefit taxable for the highly compensated or key employees who triggered the failure.¹

The eligibility test looks at who is allowed to participate and requires that the plan not favor highly compensated individuals. The contributions and benefits test looks at whether rank-and-file benefits are disproportionately smaller than what highly compensated participants receive, examining both availability and actual utilization. The key employee concentration test requires that total qualified benefits going to key employees not exceed 25% of the qualified benefits provided to all employees under the plan.¹

Plans maintained under a collective bargaining agreement are automatically treated as nondiscriminatory under Section 125.¹ Everyone else should test annually. Most employers hand this off to a benefits administrator or third-party administrator because the utilization piece can get detailed.

The Social Security Trade-Off

There’s one cost to pre-tax premiums that rarely gets discussed. Because a salary reduction lowers the wages subject to FICA, it also lowers the earnings the Social Security Administration uses to calculate your future retirement benefit. The same mechanism that saves you 7.65% today shaves a little off the Social Security income you’ll see decades from now.⁷

For most workers the trade is worth it. The immediate savings on a $6,000 annual premium comfortably outweigh a marginal reduction in a benefit check 20 or 30 years away. If you’re in the last few years before retirement, though, and your current earnings would otherwise be among your highest 35 years (the period Social Security uses in its calculation), the effect could be more noticeable. Worth understanding before you elect, not after.

Ongoing Compliance

Premiums deducted pre-tax must be excluded from taxable wages on the employee’s Form W-2. Employers also report the total cost of employer-sponsored health coverage in Box 12 (Code DD) of the W-2, but that entry is informational and does not make the coverage taxable.⁸ Getting this wrong creates headaches at tax time and potential penalties in a payroll audit.

A common misconception is that a POP itself needs a Form 5500 filing. It does not. The IRS suspended Form 5500 filing for cafeteria plans through IRS Notice 2002-24, and that suspension is still in effect. The underlying welfare plans funded through the POP may independently require a Form 5500 if they cover 100 or more participants at the start of the plan year, but that obligation comes from ERISA and attaches to the health plan, not the Section 125 wrapper.

The written plan document is not a one-and-done exercise. It should be updated whenever the employer changes which benefits are offered, modifies eligibility, or adjusts which mid-year election changes are permitted. If the IRS audits the plan and the document doesn’t match how the plan is actually running, its tax-favored status is at risk, and every pre-tax deduction taken during the noncompliant period can become retroactively taxable.

1
Office of the Law Revision Counsel. 26 USC 125 – Cafeteria Plans
2
Internal Revenue Service. Topic No. 751 – Social Security and Medicare Withholding Rates
3
Internal Revenue Service. FAQs for Government Entities Regarding Cafeteria Plans
4
Office of the Law Revision Counsel. 26 USC 79 – Group-Term Life Insurance Purchased for Employees
5
Internal Revenue Service. IRS Notice 2022-41
6
Internal Revenue Service. Tax Treatment of Cafeteria Plans (TD 8878)
7
Social Security Administration. FICA and SECA Tax Rates
8
Internal Revenue Service. Form W-2 Reporting of Employer-Sponsored Health Coverage