What is an IRC125?

IRC125 is a plan that allows employees to pay medical expenses and insurance premiums before income taxes are calculated. Established by Section 125 of the Internal Revenue Code in 1978, these plans are commonly known as cafeteria plan and was established by the City of New York and certain other New York City employees such as City University of New York. This arrangement is expressly approved by the Internal Revenue Service, and it can save enrollees as much as 40% on the payment of federal, state and local income taxes. In essence, the employee receives more net pay from wages by enrolling in this plan.

The IRC125 must be set up by an employer. Enrolled employees can deduct qualified medical expenses before taxes are paid. A person or family with regular medical expenses is likely to receive the most benefits from this type of plan. Employers also receive benefits, as a company will pay significantly less on several taxes by opening a section 125 plan.

Learn more about an IRC125

When do I need to be aware of an IRC125?

The plans might have slightly different features from company to company. There are three main types of IRC125 plans: Premium-Only Plans (POP), full Flexible Spending Accounts (FSA) and Simple Cafeteria Plans (designed for small employers). All are designed to pay for qualifying expenses before income taxes are calculated. There are some other important items you should know about IRC125:

Section 125 cafeteria plans allow for the pre-tax reimbursement of a long list of medical expenses.
Each plan must be set up by the employer and is often administered by a qualified third-party administrator, though this is not an IRS requirement.
The employee must use the funds in the plan each year or lose a portion or all of the allocated money.
Section 125 plans typically include Flexible Savings Account (FSA) options, which authorize pre-tax payroll deductions for qualifying medical and dependent care expenses. FSAs are a feature of Section 125 plans, not a separate product. Beyond the FSA, Section 125 plans also permit insurance premiums to be paid on a pre-tax basis, which provides significant additional savings.

What benefits qualify under a section 125 plan?

Not every employer-offered benefit can be paid on a pre-tax basis through a section 125 plan. The IRS defines a specific list of qualified benefits, meaning benefits whose cost can be deducted from an employee's gross income before federal taxes are calculated. Qualified benefits include:

Health, dental and vision insurance premiums
Contributions to a flexible spending account (FSA) for medical expenses
Contributions to a health savings account (HSA)
Dependent care assistance, such as childcare costs, up to annual IRS limits
Adoption assistance
Group term life insurance coverage up to $50,000

These benefits are not considered wages for federal income tax purposes when paid through a section 125 plan, which is what produces the tax savings for both employees and employers. Contributions are also generally exempt from Social Security and Medicare taxes, reducing payroll tax obligations for the organization.

What is not covered under a section 125 plan?

Certain benefits cannot be paid on a pre-tax basis through a section 125 plan regardless of how they are structured. Understanding these exclusions helps employers avoid compliance issues and helps employees set realistic expectations about what the plan covers.

Long-term care insurance is explicitly excluded from section 125 qualified benefits under the Internal Revenue Code and cannot be offered through a cafeteria plan on a pre-tax basis. Health plans purchased through the Affordable Care Act (ACA) marketplace exchanges are also generally not eligible, with limited exceptions for certain small employers.

Other benefits that fall outside the scope of a section 125 plan include gym memberships, most commuter benefits (which are governed by Section 132 of the tax code), group term life insurance coverage above $50,000 and any benefit that involves deferred compensation. If an employee elects to receive cash instead of a qualified benefit, that amount is treated as taxable wages subject to all applicable employment taxes.

Employers designing a section 125 plan should work with a qualified benefits advisor or tax counsel to confirm which benefits meet current IRS requirements, as plan offerings that fail to comply with section 125 rules can result in all employee elections becoming taxable income.

Understanding the use-it-or-lose-it rule

One of the most important features of a section 125 flexible spending account is the use-it-or-lose-it rule. Unlike a health savings account, which allows balances to roll over indefinitely from year to year, FSA funds are subject to an annual deadline. Employees who do not use their elected FSA contributions by the end of the plan year generally forfeit any remaining balance.

The IRS does allow two exceptions that employers may, but are not required to, include in their plan design. The first is a grace period of up to two and a half months after the plan year ends, during which employees can use remaining funds for eligible expenses.

The second is a carryover provision that allows employees to roll over a limited amount of unused FSA funds into the following plan year. Employers may offer one of these options but not both.

The use-it-or-lose-it rule applies specifically to FSA contributions within a section 125 plan. It does not apply to health savings account contributions or to pre-tax insurance premium payments made through the plan. Employees should review their plan documents each year to understand the specific deadline and any grace period or carryover provisions their employer has elected, and plan their healthcare spending accordingly to avoid forfeiting funds.

How does an IR125 appear on your W-2?

If you participate in a section 125 cafeteria plan through your employer, the contributions you make to the plan will reduce the wages shown in Box 1 of your W-2, your federal taxable wages.

Because pre-tax contributions are excluded from gross income before the W-2 is calculated, the amount you contributed will not appear as a separate line item in Box 1. This is by design and reflects the tax advantage the plan provides.

In some cases, particularly for employees of certain government or public sector organizations, the amount of your section 125 contributions may appear in Box 14 of your W-2, labeled as "IRC125." Box 14 is used by employers to report various state and local tax information, and its contents vary depending on your employer and location.

One important distinction: while IRC125 contributions reduce your federal taxable income, some states do not conform to the federal exclusion. If you receive a W-2 showing an IRC125 amount in Box 14, review your state's tax instructions carefully to determine whether that amount must be added back as income on your state return. Requirements vary by state, so consulting a tax professional or your employer's payroll department is recommended if you are unsure how to treat the amount.

It is also worth noting that pre-tax contributions already reflected in Box 1 of your W-2 cannot be claimed again as a medical deduction on your federal return. The tax benefit has already been applied.