Understanding Section 125 Cafeteria Plans

By Indeed Editorial Team

Updated November 3, 2021 | Published March 8, 2021

Updated November 3, 2021

Published March 8, 2021

Cafeteria plans are benefits packages that allow employees to choose from a variety of pretax compensations. To access this plan, employees give a small portion of their pretax gross income. Cafeteria plans are more flexible than other benefits plans and include options such as retirement savings and health insurance. In this article, we explain what cafeteria plans are, how they work, their requirements and how they can benefit both employees and employers.

What are cafeteria plans?

Cafeteria plans, also known as section 125 cafeteria plans, are benefits packages that allow employees to choose the healthcare plans and benefits they want. The plan gets its name from a cafeteria, where customers can choose the type of food they want to eat or drink. Section 125 is a section of the IRS tax code that allows you to convert taxable benefits such as wages into nontaxable benefits like life insurance and dependent care assistance. The section 125 cafeteria plans are separate from health insurance policies or other employee benefits programs.

Employees participating in cafeteria plans contribute a small amount of their gross income to compensate for those benefits. The company usually gives employees a certain amount of money to use when choosing their preferred benefits. If their chosen benefits package exceeds that amount, the employee pays a partial premium.

Example: Carlisle Manufacturing informs its employees that they receive $7,000 in benefits every year. This includes:

  • $5,200 for health insurance

  • $1,000 for retirement

  • $1,000 for child care

  • $1,800 for life insurance

An assistant manager chooses a benefits package that totals $8,000. Because her employer only pays up to $7,000 per year in benefits, she pays for the additional $1,000. Carlisle Manufacturing deducts this amount from her annual income.

Related: Employee Benefits: Examples of the Most Common Employee Perks

How do cafeteria plans work?

Employees who want cafeteria plans must choose one qualified benefit plan and one taxable benefit. A qualified benefit is a tax-deferred plan the company deducts from an employee's gross income under a provision code of the IRS. Examples of qualified benefits account include:

  • Health saving accounts

  • Disability insurance

  • Adoption assistance

  • Health benefits

A taxable benefit gives employees the option to add a monthly amount of money to their salary instead of putting it toward benefits plans. With company-sponsored health insurance, employers pay portions of each of their employee's premiums. If an employee opts out of the plan, they do not receive compensation for the amount their premiums might have cost.

In a section 125 plan, employers can offer employees the cost of the benefits as cash. Employees can use that money to pay for taxable benefits. This plan is the only way employers can offer employees a choice of taxable and nontaxable benefits. Plans that offer only taxable benefits are not section 125 plans.

Related: A Definitive Guide To Employee Benefits Packages

Cafeteria plan benefits

Here are four examples of cafeteria 125 healthcare benefits for employees:

A premium-only plan (POP)

With a POP plan, employees pay for their health insurance benefits with their pretax income. This plan offers simple ways for employees to get tax benefits. Traditionally, the plan had been used in combination with employer-sponsored health coverage, but employees can now use POP plans to pay for individual health insurance benefits pretax.

Health savings account (HSA)

Employees can put money from their paychecks into this savings account to pay for IRS-approved medical and healthcare expenses. The employee contributes a certain amount into the account every year, up to a maximum limit. To access this plan, employees should have a high-deductible health plan (HDHPs) so they can save for qualified medical expenses. An HDHP is a type of health insurance plan that provides low premiums and high deductibles.

Related: What Is an HSA? Benefits and Uses

Flexible spending accounts (FSA)

This savings account provides employees with money to finance their medical expenses. Employees take pretax deductions from their paychecks throughout the year to fund the account. They can use this account to reimburse medical expenses that insurance does not cover. Eligible medical expenses include nonprescription drugs, prescriptions and first-aid supplies.

Employees should spend the money saved in this account by the end of the plan year. They have a period of up to two-and-a-half months after the plan year ends to use any remaining funds saved in the account. When the year ends or the grace period is over, they lose unused funds. To make sure you keep your money, determine how much you intend to spend, estimate the costs and put the correct amount of money in your account.

Dependent care assistance plan (DCAP)

A dependent care assistance plan is a type of FSA that employees use to pay for child or dependent care. Employees caring for children under age 13 or dependent adults such as older parents or disabled spouses are eligible for the dependent care assistance plan. They also need to meet specific IRS guidelines.

You can use DCAP money to pay for eligible dependent care expenses that HSAs and FSAs might not cover. Examples of dependent care expenses include babysitting, before- or after-school programs and daycare.

Most employees are already paying for medical and care expenses with their own post-tax money. Cafeteria plans allow employees to save money on expenses they already pay for. If employees pay for these expenses upfront, they can submit their claims and documentation to their plan administrators for compensation from their accounts.

How do cafeteria plans benefit employees?

Cafeteria plans help employees save money. Their benefits include:

  • Both taxable and nontaxable benefits, which allows employees to pay for insurance and retirement plans without tax penalties

  • More take-home pay and fewer taxes deducted from employee paychecks

  • Deductions when registering for dependent care expenses

  • The ability to invest tax savings into retirement plans

How do cafeteria plans benefit employers?

Cafeteria plans also allow employers, particularly small business owners, to save money on their employees' benefits. With cafeteria plans, the employer does not have to pay Federal Insurance Contributions Act (FICA), State and Federal Unemployment Taxes (SUTA and FUTA) and workers' compensation costs, because section 125 cafeteria plans reduce payroll taxes. Low payroll taxes help reduce or eliminate the costs associated with offering cafeteria plans. In addition, any unused funds in employees' FSAs remain with the company.

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