What is a Section 125 Premium-Only Plan? Rules and regulations

What is a Premium-Only Plan?

Simply put, a Premium-Only Plan (POP) is a type of cafeteria plan, or Section 125 plan, that allows employees to pay for health insurance and other benefits with pretax money. POP plans can cover a variety of benefits, such as disability insurance, group term life insurance, and dietary supplements.

POPs can also help employees pay on a pretax basis for dental and vision insurance, flexible spending account (FSA) contributions, and health savings account (HSA) contributions.

How does a POP work?

Once an employer chooses an accredited POP provider, they will establish a plan that details the benefit premiums offered for a pretax deduction. Your employees can then choose to opt into the plan during an annual open enrollment period.

During the enrollment period, employees can choose the coverage they want and assign pre-tax contribution amounts from each paycheck for each elected benefit. When they’re paid, these contributions are withheld before the assessment of federal, state, and payroll taxes, thereby reducing their taxable income. Contributions for all employees are combined and paid to insurers.

It is important to note that Section 125 POP plans have a “use-it-or-lose-it” design. That means that at the end of the year any unused POP funds are returned to employees or forfeited by the employer.

Benefits of a Section 125 Premium-Only Plan

Premium-Only Plans offer a range of tax-saving benefits to both employees and employers. Due to pretax contributions, employers can save on payroll taxes for all individuals participating in the program. These include the Federal Insurance Contributions tax, the Federal Unemployment tax, the State Unemployment tax, and workers’ compensation insurance premiums.

On the employee end, workers effectively receive a raise without any additional cost to the employer because pretax contributions reduce their tax liability. Employees typically save between 20 and 40 percent of every dollar they contribute to the Section 125 POP plan.

Employee eligibility criteria

Section 125 Premium-Only Plans must be created by an employer, but benefits are available to employees, their spouses, and their dependents. In some cases, POP benefits may also extend to former employees, but keep in mind that the plan may not exist to primarily benefit these employees.

Section 125 rules prohibit the following individuals from participating in these plans:

• Self-employed people
• Partners within a partnership
• Shareholders who own more than two percent of an S corporation

Qualifying health plan requirements

Premium-Only Plans cover a wide range of health insurance premiums, but they cannot be used for every health care-related purpose. Some of the most common benefits that qualify for a Section 125 plan include:

• Medical, dental, and vision premiums
• Disability insurance
• Accident and health benefits
• Adoption assistance
• Dependent care assistance
• Group term life insurance coverage
• Dietary supplements
• FSAs
• HSAs

Benefits that do not meet Section 125 requirements include:

• Long-term care insurance
• Tuition assistance
• Athletic facilities
• Meals
• Commuter benefits

These benefits can still be offered by employers, but they are ineligible for pretax contributions by employees.

Required documentation for POPs

Setting up a POP is a quick process provided that you have the proper documentation. Required information includes the plan year, available benefits, eligibility, and the process for making pretax elections. Employees must be properly notified of the plan’s benefits and how they can opt into it. Working with a tax advisor or third-party administrator can simplify this process and ensure compliance with document requirements, as well as other SMB benefit requirements.

However, in addition to documentation organizations must also pass nondiscrimination testing requirements.

Nondiscrimination testing requirements

Once you have provided the right documentation and notification process for employees, there is one more crucial step to setting up a Premium-Only Plan. There are three nondiscrimination tests necessary for a Section 125 plan to work. These tests are designed to determine if the plan discriminates in favor of highly compensated or key employees in the business. The three tests are:

• Eligibility to participate
• Benefits and contribution
• Concentration

Making sure that your plan passes these three tests is absolutely essential, but it can be difficult to parse exactly what will and will not qualify. As such, it’s a good idea to hire and partner with a qualified Section 125 third-party administrator. They can not only provide the most up-to-date documentation necessary for setting up a plan and help an employer navigate compliance hurdles but also identify the best plans for your employees.

Third-party administrators typically provide employers with a plan document, summary plan descriptions, corporate resolution, customized forms, legal review, attorney opinion leaders, employee education, nondiscrimination testing, and, if necessary, an IRS Form 5500. Gathering all of this on your own can be complicated.