A cafeteria plan is an employee benefit arrangement allowing workers to choose how they receive a portion of their total compensation. The plan’s purpose is to give employees the choice between receiving full compensation in taxable cash or selecting from a menu of qualified, non-taxable benefits. By electing non-cash benefits, employees effectively reduce their taxable income. This structure is a common method for employers to deliver benefits while maximizing their value for the workforce.
Defining a Section 125 Cafeteria Plan
A cafeteria plan is formally defined by Internal Revenue Code (IRC) Section 125, which provides its official name. This section stipulates that the plan must be a written document maintained by an employer. It grants employees the option to choose between receiving taxable compensation (cash) or electing non-taxable qualified benefits. Qualified benefits are those generally excludable from an employee’s gross income under a specific IRC provision.
The plan’s name comes from the idea that employees “pick and choose” from a menu of benefits. To qualify under Section 125, the plan must offer at least one taxable benefit and one qualified benefit, such as health plans or dependent care assistance. The Section 125 structure is the only mechanism allowing employees to choose between cash and certain non-taxable benefits without the benefit automatically becoming taxable.
How Cafeteria Plans Create Tax Savings
The financial advantage of a cafeteria plan stems from pre-tax contributions, which reduce the employee’s gross income. Funds contributed toward qualified benefits are deducted from paychecks before federal and state income taxes are calculated. This results in lower reported taxable income, leading to a smaller tax liability and higher net take-home pay.
The tax exclusion also provides savings on payroll taxes for both the employee and the employer. Employee contributions are exempt from Federal Insurance Contributions Act (FICA) taxes, which fund Social Security and Medicare. Employers avoid paying their matching portion of the FICA tax on the contributed amount, reducing payroll tax expenses. The combined savings on income tax and FICA taxes incentivize participation for both parties.
Common Benefit Options Within the Plan
Premium Only Plans (POP)
The Premium Only Plan (POP) is the simplest and most widely implemented type of cafeteria plan. It allows employees to pay their share of group health, dental, and vision insurance premiums on a pre-tax basis. Routing premium payments through a POP allows the employee to immediately realize tax savings on a significant monthly expense. The POP structure is foundational because it fulfills the requirement of offering a choice between cash and a qualified benefit.
Flexible Spending Arrangements (FSA)
Flexible Spending Arrangements (FSAs) allow employees to set aside pre-tax dollars to pay for qualified out-of-pocket medical expenses. Unlike the POP, a Health FSA is used for expenses such as deductibles, co-payments, and prescription costs. The employee elects a specific annual contribution amount. This amount is generally made available in full on the first day of the plan year, even if contributions have not yet been fully deducted from the paycheck.
Dependent Care Assistance Programs (DCAP)
Dependent Care Assistance Programs (DCAP) allow employees to use pre-tax funds for the care of qualifying dependents. This includes children under 13 or a dependent incapable of self-care. Primary uses include expenses like daycare, preschool, and summer day camp. The annual exclusion limit is typically $5,000 per household, or $2,500 for a married individual filing separately. DCAP funds are unique because employees can only be reimbursed up to the amount they have contributed to the account so far during the plan year.
Health Savings Accounts (HSA) Funding
Health Savings Accounts (HSAs) are tax-advantaged accounts used with a high-deductible health plan, but they are not inherently part of a cafeteria plan. However, to make HSA contributions via a pre-tax payroll deduction, the funding must be processed through the employer’s Section 125 plan. This routing ensures the employee’s contributions avoid FICA taxes, a benefit unavailable if the employee contributes outside the payroll system. The Section 125 plan acts as the administrative conduit to maximize the tax benefits of the HSA contribution.
Strict Rules for Unused Funds
The rule governing Flexible Spending Arrangements is the “use-it-or-lose-it” rule, a consequence of the tax code prohibiting deferred compensation in cafeteria plans. This rule mandates that any funds remaining in an FSA at the end of the plan year must be forfeited to the employer. Employees must carefully estimate their annual expenses to avoid losing contributions.
Employers can adopt one of two exceptions to mitigate this forfeiture rule, but they cannot offer both simultaneously. One option is a grace period, which extends the time employees have to incur eligible expenses by up to two months and 15 days into the following plan year. The other exception permits a limited carryover of unused funds from a Health FSA into the next plan year. This carryover allows employees to retain a small portion of funds to cover future expenses.
Rules Governing Employee Enrollment and Changes
Employee elections within a Section 125 plan are subject to an irrevocability rule, meaning the election cannot be changed during the plan year. This regulation ensures the integrity of the plan’s pre-tax status. Employees must make their benefit elections during the annual open enrollment period, committing to them for the subsequent 12-month period.
The Internal Revenue Service allows exceptions to this rule through Qualifying Life Events (QLEs), which permit mid-year election changes. These events must be consistent with the requested change. QLEs include marriage, divorce, birth or adoption of a child, or a change in employment status for the employee or spouse. An employee experiencing a QLE is given a limited window to request a corresponding change in their cafeteria plan election.
Employer Requirements and Plan Administration
To legally offer a Section 125 cafeteria plan, employers must establish a formal, written plan document. This document must describe the benefits, eligibility rules, and election procedures. It serves as the legal foundation and must be in place before the plan’s effective date. Without this documentation, all benefits provided risk losing their favorable tax treatment and could be considered taxable income for employees.
Employers are also responsible for performing annual non-discrimination testing. These tests ensure the plan does not favor Highly Compensated Employees (HCEs) or Key Employees. They confirm that lower-paid employees receive a proportionate share of benefits compared to leadership. Failure to pass these tests can result in the loss of tax-advantaged status for HCEs, requiring them to include the benefit value in their taxable income. Employers must also comply with specific annual reporting requirements to the IRS regarding the plan’s operation.