How Do Employers Calculate Payroll Tax Savings with a Section 125 Plan?

A Section 125 cafeteria plan is one of the most effective ways for employers to reduce payroll taxes while offering valuable benefits to employees. By allowing employees to contribute pre-tax dollars toward health insurance premiums, medical expenses, and dependent care, businesses can significantly lower their taxable payroll—resulting in substantial payroll tax savings.

But how much can your company actually save? This guide breaks down how to calculate payroll tax savings with a Section 125 plan, ensuring that employers maximize their cost reductions while staying compliant with IRS regulations.

How Section 125 Plans Reduce Payroll Taxes

1. Lowering Taxable Payroll

When employees contribute pre-tax dollars to a Section 125 plan, those contributions are not subject to payroll taxes (FICA, FUTA, and state unemployment taxes).

For employers, this means:

• Lower gross taxable wages
• Reduced Social Security and Medicare (FICA) tax obligations
• Lower Federal Unemployment Tax (FUTA) and state unemployment taxes

Since FICA tax rates are 7.65% for employers, the more employees contribute pre-tax, the more employers save in payroll taxes.

 

Step-by-Step Payroll Tax Savings Calculation

Example Scenario

Company Profile:

• Number of employees: 50
• Average annual salary per employee: $50,000
• Average pre-tax contributions per employee: $3,000 (for health insurance, FSA, or dependent care)

Step 1: Calculate the Total Pre-Tax Payroll Reduction

Pre-tax payroll deductions per employee: $3,000
Total pre-tax deductions for all employees:
50 employees × $3,000 = $150,000

Step 2: Calculate Employer Payroll Tax Savings

Since FICA tax (Social Security + Medicare) is 7.65%, the employer savings from reduced taxable payroll is:

$150,000 × 7.65% = $11,475 in FICA tax savings

Additionally, employers may save on FUTA and state unemployment taxes, which vary by state but typically range from 0.6% to 6%.

Assuming FUTA and state unemployment taxes total 1.5%, additional savings would be:

$150,000 × 1.5% = $2,250

Step 3: Calculate Total Annual Employer Savings

Payroll Tax	Savings Amount
FICA (7.65%)	$11,475
FUTA & State Unemployment Tax (1.5%)	$2,250
Total Annual Savings	$13,725

By implementing a Section 125 plan, this business saves $13,725 annually—without reducing employee compensation or benefits.

For a deeper look at how Section 125 plans benefit employers, read Section 125 Program and FICA Tax Savings: How Employers Benefit.

 

Factors That Impact Payroll Tax Savings

Several factors influence how much employers can save with a Section 125 plan, including:

1. Employee Participation Rates

• The higher the participation rate, the greater the payroll tax savings.
• Employers should educate employees on how pre-tax contributions reduce taxable income to encourage enrollment.

2. Contribution Limits

• Health FSAs: $3,050 (2024 IRS limit)
• Dependent Care FSAs: $5,000 per household
• Health Insurance Premiums: No cap—varies by employer plan

3. Employer Payroll Tax Rate

• FICA tax savings are always 7.65%, but FUTA and state unemployment tax savings vary.
• Employers in states with higher unemployment tax rates may save even more.

For a cost breakdown of Section 125 administration, read What Are the Costs of Administering a Section 125 Plan?.

 

FAQs

1. How much can an employer save per employee?

Employers typically save $600-$700 per employee per year in payroll taxes when employees participate in a Section 125 plan.

2. Do Section 125 plans affect Social Security and Medicare contributions?

Yes, because pre-tax contributions lower taxable wages, they also reduce Social Security and Medicare payroll tax contributions.

3. Can payroll tax savings be reinvested into other benefits?

Absolutely. Many employers use Section 125 tax savings to fund additional employee benefits, such as:

• Employer-sponsored HSA contributions
• Expanded wellness programs
• Bonuses or wage increases

4. Are there any risks to offering a Section 125 plan?

The primary risks are compliance-related. Employers must:

• Ensure proper documentation and plan setup.
• Conduct annual nondiscrimination testing to prevent favoring highly compensated employees.
• Stay compliant with IRS and ACA regulations.

5. Does every employee have to participate in the Section 125 plan?

No, participation is voluntary, but higher participation rates result in greater payroll tax savings for employers.

 

Start Reducing Payroll Taxes Today

A Section 125 plan is a cost-effective strategy for employers to reduce payroll taxes, enhance benefits, and increase employee take-home pay. Talk with an expert today to discover how much your company can save.

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