Tax Benefit Strategies
Section 125 & Payroll Tax Glossary
Understanding the terminology behind Section 125 cafeteria plans and payroll tax savings can help you make informed decisions for your business. Here are the key terms you should know.
- Section 125 Cafeteria Plan
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An employer-sponsored benefits program authorized by Section 125 of the Internal Revenue Code that allows employees to pay for qualified benefits with pre-tax dollars. This reduces taxable income for both employees and employers, resulting in significant payroll tax savings.
- FICA Tax
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Federal Insurance Contributions Act tax, which funds Social Security and Medicare. FICA consists of:
- Social Security tax: 6.2% on wages up to the annual limit ($168,600 in 2024)
- Medicare tax: 1.45% on all wages (no limit)
Both employers and employees pay FICA, totaling 7.65% each. Pre-tax contributions through Section 125 plans reduce FICA-taxable wages.
- Hospital Indemnity Insurance
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A type of supplemental health coverage that pays a fixed cash benefit directly to the policyholder when they experience a covered health event—such as a hospital stay, surgery, or emergency room visit—regardless of actual medical costs incurred.
Key features:
- Benefits paid directly to you, not healthcare providers
- Can be used for any purpose (medical bills, rent, groceries)
- Supplements—does not replace—major medical insurance
- Fully insured through licensed insurance carriers
- Pre-Tax Deduction
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A payroll deduction taken from an employee's gross pay before federal income tax, state income tax, and FICA taxes are calculated. This reduces the employee's taxable income and the employer's payroll tax liability on that amount.
- FUTA (Federal Unemployment Tax)
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Federal Unemployment Tax Act—a federal payroll tax paid exclusively by employers (not deducted from employee wages). The FUTA rate is 6% on the first $7,000 of each employee's annual wages, but most employers receive a credit of up to 5.4% for paying state unemployment taxes, reducing the effective rate to 0.6%.
- SUTA (State Unemployment Tax)
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State Unemployment Tax Act—a state-level payroll tax paid by employers to fund state unemployment insurance programs. Rates vary by state (typically 1-5%) and are based on the employer's experience rating (claims history).
- Flexible Spending Account (FSA)
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A tax-advantaged account offered through Section 125 cafeteria plans that allows employees to set aside pre-tax dollars for:
- Health FSA: Qualified medical expenses (2026 limit: $3,400)
- Dependent Care FSA: Child care or elder care expenses (limit: $5,000)
FSAs generally follow a "use it or lose it" rule, though limited rollover or grace periods may apply.
- Health Savings Account (HSA)
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A tax-advantaged savings account available only to individuals enrolled in a High Deductible Health Plan (HDHP). HSAs offer "triple tax advantages":
- Tax-deductible contributions
- Tax-free investment growth
- Tax-free withdrawals for qualified medical expenses
2026 contribution limits: $4,300 (individual) / $8,550 (family)
- High Deductible Health Plan (HDHP)
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A health insurance plan with a higher deductible than traditional plans. HDHPs are required for HSA eligibility. For 2026:
- Minimum deductible: $1,650 (individual) / $3,300 (family)
- Maximum out-of-pocket: $8,300 (individual) / $16,600 (family)
- Nondiscrimination Testing
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IRS-required testing to ensure Section 125 plans do not disproportionately favor highly compensated employees (HCEs) or key employees over rank-and-file workers. Plans that fail testing may lose tax benefits for the favored employees.
- Salary Reduction Agreement
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A written agreement between an employer and employee authorizing pre-tax payroll deductions for Section 125 benefits. Employees elect their benefit amounts during the annual enrollment period, and the agreement remains in effect for the plan year unless a qualifying life event occurs.
- Qualifying Life Event (QLE)
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A significant life change that allows employees to modify their Section 125 benefit elections outside the annual enrollment period. Common QLEs include:
- Marriage or divorce
- Birth or adoption of a child
- Death of a spouse or dependent
- Loss of other health coverage
- Change in employment status (for employee or spouse)