FICA Tax Explained How Section 125 Cafeteria Plans Reduce Payroll Taxes

What Does “FICA” Mean? (Definition of FICA)

FICA stands for the Federal Insurance Contributions Act, the law authorizing payroll taxes that fund Social Security and Medicare programs. In practice, FICA taxes are mandatory deductions from each employee’s wages, with a matching contribution required from the employer. In other words, employees and employers both pay FICA taxes on wages. The funds go into federal programs that provide retirement income, disability benefits, and healthcare for retirees. From an employer’s perspective, FICA represents a significant portion of payroll taxes that you must calculate and remit each pay period. As an employer, you are responsible for withholding the employee’s share from paychecks and paying your own employer share, then reporting both to the IRS.​

Key point: FICA taxes are often called “payroll taxes,” distinct from income taxes. Unlike federal income tax withholding which varies by an employee’s earnings and exemptions, FICA is a flat percentage applied equally to virtually all earned income. This makes it easier to calculate but also means it’s a substantial fixed cost for employers hiring W-2 employees.

FICA = Social Security Tax + Medicare Tax

FICA actually combines two separate taxes:

1) Social Security (officially OASDI - Old-Age, Survivors, and Disability Insurance) and

2) Medicare (Hospital Insurance).

Each has its own rate and rules. Here’s the breakdown:

1. Social Security Tax: 6.2% of an employee’s gross wages is withheld for Social Security, and the employer pays a matching 6.2%. This tax funds benefits for retirees, survivors, and people with disabilities. However, Social Security tax has an annual wage base limit, meaning income above a certain threshold isn’t taxed for Social Security in that year. For example, in 2025 the wage base limit is $176,100, and it rises to $184,500 in 2026. Wages beyond that amount are exempt from the 6.2% Social Security tax. The maximum Social Security tax per employee in 2026 would therefore be about $11,439 (6.2% of $184,500) paid by the employer, and the same amount by the employee. This cap is adjusted annually.

1. Medicare Tax: 1.45% of gross wages is withheld for Medicare hospital insurance, and employers also contribute 1.45%. Unlike Social Security, Medicare tax has no wage limit every dollar of earnings is taxed for Medicare. Thus, high earners continue to pay Medicare tax on all wages. In fact, employees with very high incomes pay an Additional Medicare Tax of 0.9% on wages over $200,000 this part is not matched by employers. For most employees, though, the Medicare rate stays at 1.45%.

Adding these together, the standard FICA tax rate is 7.65% of wages for the employee and 7.65% for the employer, for a total of 15.3% on each dollar of wages up to the Social Security wage cap. This dual contribution is what makes FICA a significant expense. It’s essentially a payroll deduction on the employee side and an equal payroll expense on the employer side. The result is that for a $50,000/year salary, roughly $3,825 is paid in FICA tax by the employee (deducted from paychecks), and another $3,825 is paid by the employer out of company funds over the year.

Note: FICA is separate from federal income tax withholding. Federal and state income taxes depend on the employee’s earnings level and withholding allowances, while FICA is a flat percentage. Both, however, are taken out of gross pay. If you look at a pay stub or do a paycheck estimator, you’ll see line items for federal income tax, Social Security tax, and Medicare tax plus any state/local taxes. Together, these payroll deductions reduce the employee’s take home pay from the gross amount.

Calculating FICA and Other Payroll Taxes on a Paycheck

Calculating FICA withholding is straightforward because the percentages are fixed. For any given paycheck:

1. Social Security Withholding: Multiply the employee’s taxable wages by 6.2% (0.062) up to the year to date wage base limit. If the employee has already earned over the limit for the year, no Social Security is withheld for the remainder. For example, if an employee’s bi-weekly gross pay is $2,000, the Social Security deduction is $124 which is 6.2% of $2,000, until they reach the cap for the year.
2. Medicare Withholding: Multiply the employee’s wages by 1.45% (0.0145). Using the same $2,000 paycheck, the Medicare deduction is $29. There is no cap, so this calculation doesn’t stop at a limit.
3. Employer matching: The employer would contribute an additional $124 for Social Security and $29 for Medicare for that paycheck, booking those amounts as payroll tax liabilities.

These calculations happen automatically in most payroll systems. Many employers use payroll services or software to handle this. If you use a local payroll company or a big provider, their systems will compute FICA withholding and the employer’s portion for each payroll run. Still, it’s good to understand the math or double-check using a payroll tax estimator if needed. Calculating payroll taxes accurately ensures you deposit the right amount and avoids IRS penalties.

Besides FICA, employers also pay other payroll taxes like federal and state unemployment insurance. For instance, under FUTA (Federal Unemployment Tax Act), employers pay a small percentage typically 0.6% after credits on the first $7,000 of each employee’s wages for federal unemployment or employees do not pay this tax. This is separate from FICA and is employer only. Additionally, you must withhold federal and state income taxes from paychecks as required. All these together constitute the overall payroll tax obligations. FICA, however, usually represents the largest portion of mandatory payroll taxes due to that 7.65% rate on every dollar of wages, so any reduction in FICA-taxable wages can mean significant savings.

Why Reducing FICA Taxable Wages Helps Employers and Employees

Both employers and employees have a stake in reducing the amount of wages subject to FICA, as long as it’s done in a legal, IRS-approved way. For employees, less FICA withholding means more take-home pay (or more money directed to benefits rather than taxes). For employers, lowering the FICA taxable payroll means paying 7.65% less on every dollar excluded.

To illustrate, imagine an employee has a gross salary of $60,000. Normally, the employee pays $4,590 in FICA tax over the year (7.65% of $60k) and the employer also pays $4,590. But suppose $5,000 of that salary is redirected into pre-tax benefits for example, the employee’s health insurance premiums or contributions to a certain benefit plan. In that case, only $55,000 is subject to FICA. The employee’s FICA tax becomes ~$4,207 and the employer’s FICA cost similarly ~$4,207, saving each of them about $383 for the year. The employee also saves on income taxes for that $5,000, so their net paycheck reduction is even smaller. Across many employees, these savings add up quickly an employer might save over 7% of payroll costs on the portions of wages that are made pre-tax. In essence, an employer could potentially save around $1,000 or more per employee per year by maximizing allowable pre-tax benefits, while employees enjoy higher net pay or valuable benefits at lower cost.

So what is this magic method to legitimately shield a portion of wages from FICA?

The answer is an IRS-governed arrangement called the Section 125 cafeteria plan often referred to in conversation as offering “pre-tax benefits” or a “cafeteria plan”. It allows a menu of benefit options that employees can choose to pay for with pre-tax dollars, hence reducing taxable wages. Let’s explore how it works.

Section 125 Cafeteria Plans is The Key to FICA Tax Savings

A Section 125 plan named for Section 125 of the Internal Revenue Code is a benefit plan that lets employees pay for certain benefits with pre-tax dollars. It’s commonly called a “cafeteria plan” because employees get to pick and choose from a menu of benefit options, similar to selecting items in a cafeteria. These options often include things like health insurance premiums, dental or vision insurance, flexible spending accounts (FSAs) for healthcare or dependent care, health savings account contributions, certain life or disability insurance premiums, and other qualified benefits. When an employee elects to put some of their salary toward those benefits, that portion of their income is not counted as taxable income for federal income tax or for FICA (Social Security and Medicare) purposes. In other words, money used for approved pre-tax benefits does not show up as wages on the employee’s W-2 for those taxes. Both the employee and the employer get to skip paying taxes on that portion of compensation.

From the employer’s perspective, implementing a Section 125 plan can significantly reduce your FICA liability. Employers save on payroll taxes Social Security and Medicare for every dollar diverted into the cafeteria plan. At the same time, employees benefit by saving on their income tax and FICA taxes for the amount of their contributions, which can increase their take-home pay or make benefits more affordable.

It’s a true win-win scenario: employees receive valuable benefits or simply more net pay using tax-free dollars, while employers lower their tax bill.

Let’s break down a simple scenario: Say an employee making $4,000 monthly decides to contribute $300 per month to a flexible spending account and pay $200 per month toward their health insurance premium through a Section 125 plan that’s $500/month pre-tax. That $500 is not subject to FICA. Over the year, about $6,000 of that employee’s salary is shielded from FICA tax. The employer saves 7.65% of $6,000 (around $459) in FICA contributions, and the employee also saves 7.65% (another ~$459) plus whatever income tax bracket applies for that $6,000. The employee’s net take-home is higher than it would be if they paid for those expenses post-tax, and they still get the benefits insurance coverage, FSA funded by that $6,000. Multiply that by numerous employees, and the payroll savings for the company can be substantial over the year. No wonder savvy businesses call this “payroll savings” which is directly shrinks the taxable payroll base without cutting employees’ gross pay or hourly rates.

Section 125 = “Cafeteria Plan” or “Pre-Tax Benefits” in Plain English

In casual conversation, many employers and HR professionals will talk about setting up “pre-tax benefits” or a “cafeteria plan” rather than citing the tax code number. They might say something like, “We need to offer a cafeteria plan so our team can pay for their healthcare with tax-free dollars.” This is referring to the Section 125 plan mechanism. The term “cafeteria plan” nicely captures the idea that employees have a menu of benefits and can choose which to spend their allocation on.

The core principle is the same: allow certain expenses to be paid pre-tax. By doing so, the business is effectively leveraging the tax code to reduce payroll tax obligations under FICA and employees save on their FICA and income taxes as well.

Another term you might hear is PCMP, which stands for Preventative Care Management Program, this is essentially a specific type of Section 125 arrangement some providers offer, focusing on wellness benefits. A PCMP is usually paired with a Section 125 cafeteria plan and a self-insured medical reimbursement plan to create a compliant way to funnel a fixed amount of each employee’s wages into an account for preventive care or wellness expenses. The structure is designed to meet IRS rules so that those amounts become pre-tax, lowering FICA taxable wages in the process. In practice, whether it’s called a PCMP or another fancy name, it’s a variation on the cafeteria plan concept, giving employees benefits like telehealth, screenings, or wellness programs funded pre-tax, and thus saving the employer FICA dollars. The Verified Payroll Framework offered by some compliance companies such as FICA Compliance Group’s program is an example of a structured approach to implement these kinds of plans inside your existing payroll system without reducing employees’ net pay. The good news is that these strategies are based on well established tax law not loopholes or temporary tax gimmicks. They rely on long-standing IRS code provisions (Section 125, 105, etc.) and ACA compliant benefit designs to ensure the tax savings are legitimate and sustainable.

Setting Up a Section 125 Plan with Compliance Considerations

While the concept of a Section 125 cafeteria plan is simple, it’s critical to implement it correctly. The IRS has specific requirements for plan documentation and nondiscrimination. To legally establish a Section 125 plan, an employer must adopt a written plan document that describes the benefits and meets all IRS guidelines. The plan must be offered to employees on a nondiscriminatory basis meaning you can’t favor owners or highly-paid employees unfairly. There are tests to ensure that the plan doesn’t give a disproportionate benefit to key employees or executives. Additionally, you have to follow certain annual reporting and notification rules for example, communicating plan benefits to employees and perhaps filing Form 5500 if your plan is part of a welfare benefit plan of a certain size. These compliance steps are important to preserve the tax-advantaged status of the plan.

Many companies choose to work with a payroll provider or a third-party administrator to handle the setup and administration of a Section 125 plan. Your existing payroll company might offer cafeteria plan administration services, or there are specialty firms and even compliance software platforms that focus on these tax-saving benefit programs. They can assist with creating the plan documents, obtaining any needed approvals for supplementary benefits like signing up with a provider for a wellness benefit program, and integrating the deductions into your payroll process. Automating compliance is wise for instance, ensuring that the pre-tax deductions are correctly applied each payroll and that any required filings are done. Modern HR and compliance software can also help track enrollment and handle adjustments, making the process easier for HR managers. The goal is a seamless integration where the Section 125 deductions happen in each payroll run just like health insurance or 401(k) deductions, with minimal manual effort.

Once the plan is in place, the employer will coordinate with the payroll team or provider to implement the new payroll deductions. It might involve adding new deduction codes e.g., “Section125 Benefit” with a set amount per pay period. It’s a relatively simple change to a payroll system, but it yields immediate results: on the next paycheck, you’ll see slightly lower taxable wages and thus lower FICA withholding and matching. Many employers are pleasantly surprised to see FICA tax savings start appearing as soon as the first pay cycle after implementation. Of course, employees should be educated on their new benefits as well, typically through an open enrollment or a meeting (often called a “town hall” or info session) where the plan is explained. When employees understand that opting into these benefits won’t hurt their take-home pay much if at all and actually provides value, participation is usually high, which in turn maximizes the employer’s savings too.

Tip: It’s useful to use a paycheck calculator tool to show employees how choosing a pre-tax benefit affects their net pay. Because the money is tax-free, a $50 deduction for a benefit might only reduce their take-home pay by ~$40 depending on their tax bracket. This helps employees appreciate the tax-free dollars concept. Meanwhile, the employer saves FICA on that $50. Highlighting the payroll savings and improved benefits can boost buy-in from both company leadership and staff.

Conclusion-Big Payroll Tax Savings, Done The Right Way

FICA taxes are a fact of life for employers and employees, they fund important programs but can take a substantial bite out of payroll. However, by understanding the meaning of FICA and leveraging proven strategies like Section 125 cafeteria plans, businesses can lawfully reduce their FICA tax exposure. The definition of FICA doesn’t change, but the definition of smart payroll management now includes utilizing pre-tax benefits to everyone’s advantage. Employers who implement these plans see lower tax payments on Social Security and Medicare, while employees enjoy more disposable income or expanded benefits at no extra cost. It’s truly a FICA tax win-win.

As we head into 2026, savvy business owners are looking not just at income tax credits or one-time perks, but at sustainable, ongoing savings. Federal Insurance Contributions Act tax obligations will always be there, but you have tools to manage how much of your payroll is exposed to FICA. By adopting a compliant Section 125 program essentially, funding benefits with what would have been tax dollars companies are reclaiming roughly 7.65% of those dollars. Over years, this can mean thousands saved per employee, adding to tens or hundreds of thousands in savings for the organization, all while enhancing your benefits package for your team.

Remember that proper setup and compliance are paramount. Always follow IRS guidelines, maintain your plan documents, and if in doubt, consult with a tax professional or a FICA compliance specialist.

The results are worth it: lower payroll tax bills, happier employees, and the peace of mind that you’re not leaving money on the table. In the landscape of business, that’s a competitive advantage you don’t want to miss. Here’s to payroll tax savings and a financially healthier future for your business and your employees!

P.S. This blog or article is intended for general informational purposes and does not constitute legal or tax advice. Consult with a professional for advice tailored to your specific situation.