Section 125 Plans - Overview

Before offering employees the option of pre-tax deductions in their paycheck, the Internal Revenue Service requires all employers to adopt a Section 125 Agreement.  For many clergy, it is preferable to deduct the pastor’s portion of the HealthFlex uniform rate on a pre-tax basis.  Additionally, if your pastor participates in a flexible spending account, their annual election should be deducted pre-tax.  Allowing pre-tax deductions will lower taxable income and may affect future benefits such as social security. The employee’s annual W-2 should list each of their pre-tax deductions and the total annual amount deducted.

Setting up and implementing a pre-tax Section 125 Cafeteria Plan is fairly easy. Essentially, an employer needs to establish the type of plan that meets the needs of their clergy (and other employees), set up the plan with proper documentation and distribute and save the employee election (declination) forms.

What is a cafeteria plan?

A cafeteria plan is a separate written plan maintained by each church (the employer) for employees that meet the specific requirements and regulations of Section 125 of the Internal Revenue Code. It provides employees with an opportunity to receive certain benefits on a pretax basis.

Benefits include the following:

  • Accident and health benefits
  • Employee Retirement Plans
  • Adoption assistance
  • Medical Reimbursement Accounts
  • Dependent Care Accounts
  • Group-term life insurance coverage
  • Health savings accounts, including distributions to pay long-term care services

The written plan must specifically describe all benefits and establish rules for eligibility and elections.

A section 125 plan is the only means by which an employer can offer employees a choice between taxable and nontaxable benefits without the choice causing the benefits to become taxable. A plan offering only a choice between taxable benefits is not a section 125 plan.

Is there a filing requirement for a cafeteria plan?

Generally, no. Employers are required to formally adopt a Section 125 plan and retain a copy for their records.  They should annually “renew” the Section 125 plan.   If you only have a cafeteria plan, you are not required to file Form 5500 or Schedule F. However, if you have a welfare benefit plan, you may be required under Department of Labor regulations to file a return for that plan.

How does a cafeteria plan work?

Employer contributions to the cafeteria plan are usually made pursuant to salary reduction agreements between the employer and the employee in which the employee agrees to contribute a portion of his or her salary on a pre-tax basis to pay for the qualified benefits. Salary reduction contributions are not actually or constructively received by the participant. Therefore, those contributions are not considered wages for federal income tax purposes. Each employee must complete the Employee Election Form, either upon adoption of the Section 125 plan or when the employee experiences a change in benefits or is newly hired.  The Employee Election Form should be kept with the church payroll records.

Instructions to adopt IRS Section 125 Tax Code (Cafeteria Plan) for your church

Complete all parts of the Section 125 Cafeteria Plan Adoption Agreement.

At a Church Council meeting, vote to approve the Adoption Agreement.  You will need to “renew” the agreement annually.

The church Treasurer must sign the Adoption Agreement and retain a copy for the church financial/payroll records.

Distribute the Employee Election Form to your clergy for their completion and signature. The original must be retained in the employee’s file and a copy must be given to your payroll provider so that the employee request is properly implemented.