Section 125 Cafeteria Plans: How Contractors Cut Payroll Tax

Crew costs keep climbing and margins do not. A Section 125 cafeteria plan is one of the few moves that lowers your payroll tax bill and raises your crew’s take-home pay at the same time, without you writing a bigger check.

It works because benefits paid through a properly documented cafeteria plan come out of wages before tax. Lower taxable wages means the employee keeps more, and it means you owe less employer payroll tax on the same compensation.

Where the savings come from

Say a foreman routes $4,000 a year through the plan for health premiums and out-of-pocket medical costs.

• The foreman avoids federal income tax and the employee half of FICA on that $4,000.
• You avoid the employer half of FICA, 7.65%, which is about $306 on that one employee.
• You also reduce the wage base for FUTA and, in most states, SUTA and workers’ compensation premiums.

Across a twenty-person crew each running a few thousand dollars through the plan, the employer-side savings routinely cover the cost of administering it several times over. Nothing about your gross payroll changes. Only the tax on it does.

The 2026 numbers

The dependent care jump is the headline. That limit sat at $5,000 from 1986 until the 2025 tax act raised it to $7,500 starting in 2026, with $3,750 for married employees filing separately. For a contractor with young field staff and office employees paying for daycare, that is the single most valuable line on the list, and it does not cost the company a dollar in additional wages.

Cafeteria plan or FSA?

These get used interchangeably and they are not the same thing. The cafeteria plan is the legal wrapper under Section 125 that permits pre-tax elections at all. An FSA is one of the benefits you can offer inside that wrapper.

The simplest version is a premium-only plan, often called a POP. It does one thing: it lets employees pay their share of health insurance premiums pre-tax. If you deduct employee premium contributions from paychecks and do not have a written Section 125 plan document, you may be taking those deductions after tax without realizing it, which is money both sides are leaving on the table.

Use it or lose it, and the one exception you get

Unused health FSA money is forfeited at year end unless the plan adopts relief. You may adopt one of these, not both:

• A grace period of up to two and a half months after year end to spend the prior year’s balance.
• A carryover of up to $680 into 2026.

Dependent care FSAs can use a grace period but not a carryover.

The rules that trip up contractors

• You need a written plan document, adopted before the plan year starts. Without one there is no Section 125 plan, and the tax treatment does not hold up.
• The dependent care increase requires a plan amendment. Your existing document almost certainly says $5,000. It will not automatically follow the law up to $7,500.
• Owners are mostly excluded. More-than-2% S corporation shareholders, partners in a partnership, and sole proprietors generally cannot participate on a pre-tax basis. Their employees can. This surprises a lot of owners who set the plan up for themselves.
• Nondiscrimination testing applies. The plan cannot disproportionately favor highly compensated or key employees. In a company with a small office group and a large field crew, this is worth testing rather than assuming.
• Elections are locked for the year unless the employee has a qualifying change in status such as marriage, birth or a change in employment.

The short version

A Section 125 plan lowers taxable wages, which cuts your FICA and FUTA and raises your crew’s net pay at no additional payroll cost. For 2026 the health FSA limit is $3,400 with a $680 carryover, and the dependent care limit rises to $7,500. You need a written plan document, you need to amend it for the new dependent care figure, and if you are a more-than-2% S corporation shareholder you are running this for your team rather than for yourself.

General information, not tax or benefits advice for your situation. Cafeteria plan design and nondiscrimination outcomes depend on your workforce and entity structure. Accounting Solutions LLP works with construction contractors nationwide.

Disclaimer: This content is provided for educational purposes only and is not legal, tax, accounting, or financial advice. Every situation is unique, so consult your own attorney, CPA, or financial advisor before making decisions based on this information.