Section 125: pre-tax health premiums
Employer premiums are excluded from income under §106; a section 125 plan takes the employee's share out of income tax, FICA and FUTA — Northwind's October payroll, worked.
Health coverage is the most tax-favored pay there is. What the employer pays for it is not the employee's income at all: §106 excludes employer-provided coverage under an accident or health plan from gross income. Northwind's $975 a month never appears on a paycheck or a W-2 as wages.
The employee's own share is ordinary pay — until a cafeteria plan says otherwise. A section 125 plan is a written plan that lets employees choose between cash and qualified benefits; choosing the benefit does not make it taxable. The simplest kind, a premium-only plan, does one thing: it moves the employee's share of the premium out of taxable wages.
Pre-tax here means pre-everything an employer withholds: a section 125 premium is excluded from federal income tax withholding, from Social Security and Medicare, and from FUTA. The Code says so for FICA directly.
Northwind's October payroll
October's salaries are September's: $8,400 of gross pay. This time $325 of it — $162.50 each — goes to the premium before tax. The register below is the payroll track's own arithmetic, run on the lower wages.
Wrong
Gross 8,400 = FICA wages − taxes − premiums 325 after tax
Right
Gross 8,400 − premiums 325 (pre-tax, §125) = FICA wages 8,075
Without a written section 125 plan, an employee's share of the premium is after-tax pay. The plan document is the difference, not the payroll setting.
§125 health premium
- Good at
- Out of income-tax wages
- Out of Social Security, Medicare and FUTA wages
- Watch for
- Needs a written cafeteria plan
- Only for the qualified benefits the plan offers
Traditional 401(k) deferral
- Good at
- Out of income-tax wages
- Grows tax-deferred in the employee's account
- Watch for
- Still in Social Security and Medicare wages
- Subject to annual deferral limits
The employer's share is never wages. The employee's share is wages unless a written §125 plan says it is not.
Where this lesson's rules come from
The sources behind this lesson's requirements, by kind. Background reading explains; it is never the authority for a rule. Anything marked as a convention is ours, not the rule-maker's.
- Federal statute
- IRC §106(a) (opens in a new tab)Employer-provided health coverage is excluded from the employee's incomeFree to read
- IRC §125(a), (d)(1) (opens in a new tab)Cafeteria plansFree to read
- IRC §3121(a)(5)(G) (opens in a new tab)Cafeteria plan payments are not FICA wagesFree to read
- IRS guidance
- IRS Pub. 15-B (2026), §1 Cafeteria Plans; §2 Table 2-1 (opens in a new tab)Employer's Tax Guide to Fringe BenefitsPDF · Free to read
- Tax — not GAAP
- IRS Publication 15 (2026), Circular E — Introduction (opens in a new tab)Withheld payroll taxes are the government's money, held in trustFree to read
- Background reading — not an authority
- Wikipedia, “Cafeteria plan” (opens in a new tab)Cafeteria planFree to read
The words this lesson teaches
Each links to its glossary definition, which also names the authority behind it and the components that render it.
- Cafeteria planA written plan that lets employees choose between cash and qualified benefits — health premiums, a health FSA, dependent care — so that what they choose is paid pre-tax: out of income-tax wages and out of FICA wages
- Gross payWhat an employee earned for the pay period before anything is withheld — salary, or hours times rate, plus overtime, bonuses and commissions. Payroll expense in the books is the gross, not what reached the bank
- Form W-2The year-end statement of an employee's wages and withholding — boxes 1, 3 and 5 for income tax, Social Security and Medicare wages — furnished to the employee and filed with the SSA by January 31, with no automatic extension
See also
- Payroll journal entries, from gross to netGross wages, employer taxes, withholding and net pay as journal entries: what each payroll run books, how to accrue it at month end, and where benefits go.
- W-2 year end for startups: boxes, deadlines, correctionsThe W-2 boxes founders get wrong (box 1 vs 3 vs 5, box 12 codes), the W-3, the SSA deadline, state copies, and how to fix a mistake with a W-2c.