Section 125 Plan Rules: What the IRS Requires Employers to Follow

• Proposed Treasury Regulation 1.125-1(c) requires a written plan, and a plan that fails the written plan rules is not a cafeteria plan, so every pre-tax deduction becomes taxable wages.
• Sole proprietors, partners and more-than-2% S corporation shareholders cannot participate in a cafeteria plan, according to IRS Publication 15-B.
• Elections are made before the plan year and are irrevocable unless a permitted change applies under 26 CFR 1.125-4.
• The 2026 health FSA limit is $3,400, with a maximum carryover of $680, per IRS Revenue Procedure 2025-32.
• A highly compensated employee for 2026 testing earned more than $160,000 in 2025, and key employees cannot receive more than 25% of total plan benefits (IRS Notice 2025-67; Internal Revenue Code Section 125(b)).

Most Section 125 problems do not start with a big mistake. They start with a small gap, such as a missing signature, an owner on the pre-tax payroll list or a mid-year change nobody documented. The IRS rules are short and specific. This guide lists each one, shows how it works in practice and tells you what to check first.

What are the Section 125 plan rules?

The Section 125 plan rules come from Internal Revenue Code Section 125 and the Treasury regulations under it. They let an employer offer a choice between taxable pay and qualified benefits, and they keep the tax savings only if the plan follows the rules. A Section 125 cafeteria plan is a written employer plan that lets employees pay for benefits such as health insurance premiums with pre-tax pay.

There are seven rules to track. The table gives the short version, and each one is explained below.

Does a Section 125 plan have to be in writing?

Yes. A Section 125 cafeteria plan must be in writing, and Proposed Treasury Regulation 1.125-1(c) says a plan that does not meet the written plan requirements is not a cafeteria plan. The plan has to describe each benefit, who can join, how elections work, how contributions are made, the maximum contribution and the plan year.

The plan must be adopted and effective by the first day of the plan year. Signing it in March for a January plan does not fix the earlier months. Benecor's guide to the Section 125 plan document→ lists every required term and the extra terms for FSAs.

Who can participate in a Section 125 plan?

Only employees can participate in a Section 125 plan. IRS Publication 15-B says a more-than-2% shareholder of an S corporation is not treated as an employee for this purpose, and sole proprietors and partners are treated as self-employed, so they cannot join either.

Family members can trip this rule too. Under the attribution rules in Internal Revenue Code Section 318, a spouse, parent or child of a more-than-2% shareholder who works in the business is treated as one for Section 125. Owners can still deduct their own health premiums, but through a different tax route. Benecor's page on Section 125 and S corporation owners→ explains the W-2 reporting.

When can employees make or change elections?

Employees must make their elections before the plan year starts, and the election is locked for the full year. Proposed Treasury Regulation 1.125-1(c) requires the plan to state that elections are irrevocable except for permitted changes. A permitted change needs a qualifying event, such as marriage, birth, loss of other coverage or a change in employment status, and the new election must fit the event.

New hires can usually make a first election when they become eligible, and the election applies going forward only. If an employer lets an employee change a deduction for no recognized reason, the plan breaks the irrevocable election rule. Benecor's guide to Section 125 qualifying life events→ walks through the events and the consistency test.

Which benefits can a Section 125 plan offer?

A Section 125 plan can offer only qualified benefits, and Internal Revenue Code Section 125(d) and (f) rule out benefits that defer pay. Common qualified benefits include employer-sponsored health, dental and vision premiums, a health FSA, a dependent care FSA, health savings account contributions and group term life insurance up to the tax-free limit.

Two benefit limits matter most in 2026:

• Health FSA: $3,400 in employee salary reductions, with a $680 maximum carryover if the plan allows one (IRS Revenue Procedure 2025-32).
• Dependent care FSA: $7,500 per household, raised from $5,000 by the One Big Beautiful Bill Act (Public Law 119-21).

Benecor's FSA contribution limits guide→ and dependent care FSA limit page→ cover the details.

What is the use-it-or-lose-it rule?

The use-it-or-lose-it rule says an employee forfeits unused health FSA money at the end of the plan year, because a cafeteria plan cannot defer compensation. Internal Revenue Code Section 125(d)(2) bars deferral, and the IRS allows only two relief options for a health FSA. The plan can offer a carryover of up to $680 for 2026, or a grace period of up to two months and 15 days after the year ends. A plan cannot offer both for the same health FSA.

This rule is also why the health FSA follows the uniform coverage rule. The employer must make the full annual election available from day one, even though the employee pays through the year. Employers carry that risk, so the plan document should say clearly which relief option applies.

What are the Section 125 nondiscrimination rules?

The Section 125 nondiscrimination rules stop a plan from favoring highly paid employees and owners. Internal Revenue Code Section 125(b) and (g) set three tests: an eligibility test, a contributions and benefits test, and a key employee concentration test. The concentration test fails when key employees receive more than 25% of the total qualified benefits the plan provides.

The 2026 test thresholds come from IRS Notice 2025-67. A highly compensated employee generally earned more than $160,000 in 2025, and an officer is a key employee when pay is above $235,000 for 2026. A more-than-5% owner is also a key employee. If a plan fails, the highly compensated or key employees lose their tax exclusion, while rank-and-file employees keep theirs.

Employers with 100 or fewer employees can avoid this testing with a simple cafeteria plan, which meets the tests through a safe harbor under Internal Revenue Code Section 125(j). Benecor explains the options in its guides to Section 125 nondiscrimination testing→ and the simple cafeteria plan safe harbor→.

What records and filings does a Section 125 plan need?

A Section 125 plan needs the signed plan document, every amendment and every employee election kept on file. The employer does not file the plan with the IRS, and IRS Notice 2002-24 removed the old Form 5500 Schedule F requirement for the cafeteria plan itself.

The benefits inside the plan can still carry their own duties. A group health plan or health FSA that falls under ERISA may need a Form 5500 once it reaches 100 participants, and the plan administrator must give participants a summary plan description. Keep election forms for each plan year so you can show the IRS who chose what and when.

What happens if an employer breaks a Section 125 rule?

If an employer breaks a Section 125 rule that voids the plan, the IRS treats the pre-tax deductions as taxable wages. The employer then owes the 7.65% employer share of FICA on those dollars (IRS Publication 15, 2026), and the employee FICA and income tax that should have been withheld. Failure-to-deposit penalties and interest can follow.

Smaller errors, such as a late election change, can usually be fixed by reversing the change and correcting payroll. Larger ones, such as no plan document or an owner in the plan, are harder to fix, and the cost grows with each quarter. A quick self-check helps.

1. Find the signed plan document and confirm its effective date is on or before the first day of the plan year.
2. Compare the payroll deduction list with the plan's benefit list, line by line.
3. Check that no owner, partner or family member of a more-than-2% shareholder has pre-tax deductions.
4. Review every mid-year election change for a matching qualifying event.
5. Run the nondiscrimination tests, or confirm the plan uses the simple cafeteria plan safe harbor.

Benecor Health sets up and maintains Section 125 cafeteria plans for W-2 employers, including the written plan, enrollment support and payroll coordination. If you want a second set of eyes on your plan, a Benecor benefits expert can walk through the checklist with you. You can also read the full Section 125 cafeteria plan guide→ or the setup steps→ before you call.

Sources: Internal Revenue Code Section 125 (26 U.S.C. 125); Proposed Treasury Regulation Section 1.125-1, Cafeteria Plans, Federal Register (August 6, 2007); 26 CFR 1.125-4, Permitted election changes; IRS Publication 15-B, Employer's Tax Guide to Fringe Benefits (2026); IRS Publication 15, Employer's Tax Guide (2026, employer FICA rate of 7.65%); IRS Revenue Procedure 2025-32 (2026 health FSA limit of $3,400 and $680 carryover); IRS Notice 2025-67 (2026 highly compensated employee and key employee thresholds); IRS Notice 2002-24 (Form 5500 Schedule F suspension); Public Law 119-21, One Big Beautiful Bill Act (2025, dependent care FSA limit of $7,500); Internal Revenue Code Sections 125(j) and 318.