When evaluating benefit options for employers and employees, Sections 105 and 125 of the tax code offer two distinct vehicles:
- Section 105 Plans (also known as HRAs or Medical Reimbursement Plans) are fully employer-funded.
- Section 125 Plans (often called cafeteria plans) allow employees to make pre‑tax contributions toward their benefits.
Although both can help reduce federal income tax and payroll taxes, the eligibility rules, reimbursable expenses, and nondiscrimination requirements differ significantly.
What is a Section 125 (Cafeteria) Plan?
Under Section 125, employers allow employees to convert part of their taxable wage into pre‑tax elections for qualified benefits (e.g., health premiums, FSAs, HSAs, dependent care, group‑term life insurance).
Employees benefit by lowering taxable income—and employers save on FICA and FUTA taxes—while building an attractive, flexible benefits package Venteur.
Plan types include:
- Full-flex cafeteria
- Simple cafeteria (safe harbor for employers < 100 employees)
- Premium-only plans (POP)
- Flexible Spending Accounts (FSAs) under the cafeteria umbrella
Some individuals—like partners, sole proprietors, and S-corp shareholders owning over 2%—cannot participate.
What is a Section 105 (Medical Reimbursement) Plan?
Section 105 Plans are employer-funded HRAs that reimburse employees for medical premiums and out-of-pocket medical expenses, federal‑tax‑free, with a business deduction for the employer.
Employers set reimbursement limits and must abide by IRS nondiscrimination rules. These plans can cover a broader range of medical expenses than FSAs or cafeteria plans—including dental, vision, prescriptions, and qualified long-term care costs.
| Feature | Section 105 Plan (HRA) | Section 125 Plan (Cafeteria Plan) |
|---|---|---|
| Funding Source | 100% employer-funded | Employee-funded via pre‑tax salary elections |
| Eligible Participants | Employers, W‑2 employees; owners may participate if employer entity allows | Most W‑2 employees, spouses, dependents; excludes >2% S‑corp owners, partners, sole proprietors |
| Reimbursable Medical Expenses | Broad: premiums, deductibles, copays, prescriptions, dental, vision, long-term care | More limited: HSA/FSA eligible expenses, premiums, dependent care, group-term life |
| Tax Treatment | Employer deduction; reimbursements excluded from employee income | Employee pre-tax contributions reduce income and payroll taxes; employer saves payroll taxes |
| Nondiscrimination Rules | Subject to Section 105(h) rules—eligibility, benefits, operational tests. Higher flexibility on exclusions | Must satisfy eligibility and benefits tests plus Key Employee Concentration Test if key employees get >25% of benefits |
| Flexibility / Control | Employer sets covered expenses and plan design; no employee contributions allowed | Employees choose which benefits to fund; flexible menu of options |
| Cost to Employer | Fully paid by employer | Minimal—employees fund their selections; employer may subsidize |
| Ease of Employee Administration | Simpler—for employers with few participants | Requires enrollment, elections, payroll integrations, annual testing |
Key Takeaways
- Choose a Section 105 Plan if you want to fully cover employee medical expenses with employer dollars and reimburse a wide range of eligible costs.
- Choose a Section 125 Plan if you want to empower employees to fund benefits with pre‑tax income while keeping employer costs low.
- If you prioritize maximum employer-funded benefits, Section 105 HRAs offer broader coverage but stricter nondiscrimination testing.
- If flexibility and minimal employer liability are top of mind, a Section 125 Cafeteria Plan may be the better fit.
Both plans offer powerful tax advantages—but they suit different needs based on company size, funding preference, and participant eligibility. Consulting with a tax advisor is recommended to ensure compliance and optimal benefits design.
