# 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.

Source: https://lopifi.com/learn/section-125-pre-tax-health-premiums
Part of: Lopifi — US GAAP books on autopilot, checked by a CPA (https://lopifi.com)

---

**How do pre-tax health insurance deductions work?** 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](https://lopifi.com/md/glossary/form-w-2) as wages.

> “Except as otherwise provided in this section, gross income of an employee does not include employer-provided coverage under an accident or health plan.”

— [IRC §106(a)](https://www.law.cornell.edu/uscode/text/26/106), Employer-provided health coverage is excluded from the employee's income

The employee's own share is ordinary pay — until a [cafeteria plan](https://lopifi.com/md/glossary/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.

> “Except as provided in subsection (b), no amount shall be included in the gross income of a participant in a cafeteria plan solely because, under the plan, the participant may choose among the benefits of the plan.”

— [IRC §125(a), (d)(1)](https://www.law.cornell.edu/uscode/text/26/125), Cafeteria plans

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.

> “under a cafeteria plan (within the meaning of section 125 ) if such payment would not be treated as wages without regard to such plan”

— [IRC §3121(a)(5)(G)](https://www.law.cornell.edu/uscode/text/26/3121), Cafeteria plan payments are not FICA wages

> “A cafeteria plan, including an FSA, provides participants an opportunity to receive qualified benefits on a pre-tax basis.”

— [IRS Pub. 15-B (2026), §1 Cafeteria Plans; §2 Table 2-1](https://www.irs.gov/pub/irs-pdf/p15b.pdf) (PDF), Employer's Tax Guide to Fringe Benefits

## Northwind's October payroll

October's salaries are September's: $8,400 of [gross pay](https://lopifi.com/md/glossary/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.

|  | September | October |
| --- | --- | --- |
| Gross pay | 8,400 | 8,400 |
| Premiums, pre-tax | — | 325 |
| Wages for income tax and FICA | 8,400 | 8,075 |
| Federal income tax withheld | 1,050 | 992 |
| Employer Social Security and Medicare | 642.60 | 617.75 |

September and October, side by side. October's wages for tax are gross less the premium.

*[Figure: payroll withholding]*

Priya Shah's October check through the withholding slicer, starting from her wages after the premium. Income tax rates on the figure are illustrative; the register above is the real withholding.

**Northwind — What pre-tax is worth.** Taking the premium pre-tax lowers the employees' withholding and Northwind's own FICA. On $325 a month of premiums, Northwind's half of Social Security and Medicare falls by about $24.86 a month, and the employees save the same on theirs, plus income tax. Small for two people; it scales with every enrollee and every raise in premium.

**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**
- Pro: Out of income-tax wages
- Pro: Out of Social Security, Medicare and FUTA wages
- Con: Needs a written cafeteria plan
- Con: Only for the qualified benefits the plan offers

**Traditional 401(k) deferral**
- Pro: Out of income-tax wages
- Pro: Grows tax-deferred in the employee's account
- Con: Still in Social Security and Medicare wages
- Con: Subject to annual deferral limits

Two pre-tax deductions that are not the same kind of pre-tax.

> **Small employers.** An employer that averaged 100 or fewer employees in either of the two preceding years can adopt a simple cafeteria plan, which — if it meets its own contribution, eligibility and participation requirements — is treated as meeting the nondiscrimination rules a regular cafeteria plan must test.

> **On the W-2.** The cost of employer-sponsored coverage goes in box 12 with code DD — informational, not taxable. The [W-2 guide](https://lopifi.com/md/startups/w2-year-end-for-startups) has who must report it.

> **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

- [IRC §106(a)](https://www.law.cornell.edu/uscode/text/26/106) — Employer-provided health coverage is excluded from the employee's income (statute)
- [IRC §125(a), (d)(1)](https://www.law.cornell.edu/uscode/text/26/125) — Cafeteria plans (statute)
- [IRC §3121(a)(5)(G)](https://www.law.cornell.edu/uscode/text/26/3121) — Cafeteria plan payments are not FICA wages (statute)
- [IRS Pub. 15-B (2026), §1 Cafeteria Plans; §2 Table 2-1](https://www.irs.gov/pub/irs-pdf/p15b.pdf) (PDF) — Employer's Tax Guide to Fringe Benefits (irs)
- [Wikipedia, “Cafeteria plan”](https://en.wikipedia.org/wiki/Cafeteria_plan) — Cafeteria plan (reference)
- [IRS Publication 15 (2026), Circular E — Introduction](https://www.irs.gov/publications/p15) — Withheld payroll taxes are the government's money, held in trust (tax)

## Read further

- https://lopifi.com/md/startups/payroll-journal-entries
- https://lopifi.com/md/startups/w2-year-end-for-startups

- **Track:** [Health & benefits](https://lopifi.com/md/learn/benefits)
- **Lesson:** Lesson 3 of 10 — 10 min
- **Terms taught:** [Cafeteria plan](https://lopifi.com/md/glossary/cafeteria-plan), [Gross pay](https://lopifi.com/md/glossary/gross-pay), [Form W-2](https://lopifi.com/md/glossary/form-w-2)
- **Previous:** [Group health insurance for a small business, Benefits · Lesson 2](https://lopifi.com/md/learn/group-health-insurance-for-small-business)
- **Next:** [HSAs and FSAs for employers, Benefits · Lesson 4](https://lopifi.com/md/learn/hsa-vs-fsa-for-employers)
- **The course:** https://lopifi.com/md/learn