What is a cafeteria benefits plan?

According to the U.S. tax code, a Section 125 cafeteria-style plan allows employees to set aside a portion of their pretax salary to pay for certain expenses. They can use their money for specific benefits that suit their lifestyles, such as child care or prescription medicine, without the employer having to provide benefits that aren’t necessary or useful to employees. It’s important to note that these plans don’t provide health insurance; they are just a way to help pay for premiums or other types of insurance coverage. 

To qualify as a cafeteria plan, there must be a taxable benefit option and a qualified pretax benefit. The taxable benefit option is usually the employee’s salary which allows the employee to take their entire salary instead of applying some of it toward a benefit plan. A qualified pretax benefit can include anything, from health and disability insurance to child care. 

Benefits of cafeteria plan

If you’re not sure if a cafeteria benefits plan is right for your company, consider the following benefits:

• Employee choice: Your employees choose how much in pretax dollars they want to contribute and how they want to spend that money.  
• Reduced tax liability: With employee contributions being pretax, they get the advantage of having a lower gross income to reduce their tax liability. This also means you pay less in payroll taxes . 
• Improved benefits packages: By giving employees more flexibility in how they spend their money and more pretax options, you can help keep your employees happier, which can improve employee retention. It can also help you attract new talent. 
• Less wasted money: From an employer‘s perspective, cafeteria plans can be more cost-effective. You’re ensuring your team members get the benefits they want instead of spending money on benefits few employees use. 
• Supportive of diverse needs: Your employees have diverse needs. For example, some employees might want to focus more on retirement savings while others might be excited to save money on child care. You can help each worker receive the benefits that best match their situation to keep everyone happier. 

Disadvantages of cafeteria benefits plans

It’s also important to look at the drawbacks of cafeteria-style plans. In some cases, you might decide the disadvantages outweigh the advantages.

Disadvantages of cafeteria benefits plans include:

• Complexity: Cafeteria plans can be complex to administer. Using a benefits administrator with experience in cafeteria plans can make it easier for your company.
• Limitations: Employees usually can’t make changes to their plans during the year, with a few exceptions. 
• Forfeited money: In some cases, employees can lose part of their contributions if they don’t use them within a specific time frame. 
• Setup fees: You’ll usually have to pay setup fees to get a cafeteria plan going. This can require you to have a large amount of money available when you switch to this plan. 

Examples of cafeteria benefits plans

Understanding how a cafeteria benefits plan works can be confusing, but looking at samples can make it easier to understand. Examples of cafeteria-style benefits plans include the following:

Health savings account

This is also known as a Premium Only Plan (POP). It allows employees to put aside a portion of their pretax salaries for certain healthcare products and services. An HSA is owned by the employee, and they can take it with them to a different job if they change companies. The HSA allows the worker to make tax-free deposits each year that can be withdrawn at any time to pay for medical expenses. Plus, if employees don’t use all their funds in a single year, it will roll over to the next one. This ability to choose their own plans can lead to higher satisfaction among employees. 

The greatest benefit of an HSA for the employer is tax benefits. Employers aren’t required to pay payroll taxes on HSA contributions, and they also receive federal income tax deductions for any payments made toward employees’ HSAs. Another advantage is HSA accounts can be moved, without penalty, from one carrier to another.

Dependent care assistance plan

This is a great option for small businesses that want to offer childcare benefits. Dependent care flexible spending accounts (DCAP) cover daycare, nursing homes and other expenses related to children and adults in an employee’s care. Staff members decide on an amount of pretax dollars to be deposited to their DCAP account every payday. According to IRS guidelines, the children must be under the age of 13, and elderly dependents must be unable to work due to physical impairment. 

Employees can deposit up to $5,000 per year into their DCAP accounts for single taxpayers and married couples and $2,500 each for married couples filing separately. Essentially, you can use it for up to $5,000 total for the family. Unused funds don’t roll over to the following year, as they do with an HSA. While $2,500 may seem like a sufficient amount, childcare may be quite costly. However, since the childcare money is a pretax benefit, it could end up saving your employees a lot more.

Flexible spending accounts

FSAs allow employees to pay for out-of-pocket medical expenses that aren’t covered by insurance with pretax dollars. This includes expenses such as annual deductibles, doctor copays, prescriptions and orthodontia — auxiliary medical costs that aren’t always covered by health insurance. FSAs can even be used to pay healthcare premiums if no other benefits are provided. Some FSAs can be connected to debit cards so expenses can be paid for directly by the employee. 

Workers can only contribute a maximum amount of $2,550, and the unused money doesn’t roll over to the next year. Unlike an HSA, an FSA is connected to the employer, so if an employee leaves the company, they lose their benefits.

Other benefit options

Using a cafeteria plan can allow you to offer other qualified benefits that might better fit the needs of your employees. Examples of additional benefits options include:

• Adoption assistance
• Group term life insurance
• Accident and health benefits

There are also some benefits that don’t qualify for cafeteria plans. Benefits that don’t qualify include:

• Long-term care insurance
• Commuter benefits
• Gym memberships
• Tuition assistance
• Moving expenses
• Employee discount programs

You can still offer those benefits to your employees; they just need to be offered separately, as they don’t qualify to be paid with pretax money.

The bottom line for managers

Every employee who participates in some form of a cafeteria-style plan will reduce payroll taxes and, therefore, reduce workers’ compensation, FICA, FUTA and SUTA costs. Cafeteria plans can also help with the costs of increased premiums if a company’s medical premiums suddenly increase.

Section 125 cafeteria plans will vary depending on the size of the company and employer needs. They can also be quite complicated to create and administer, so be sure to think of possible administration costs, especially as ongoing compliance with laws must be observed. Additionally, a company can only allow employees to change their cafeteria-style benefits once a year. So if an employee uses all their benefits at the beginning of the year before they’ve paid their yearly contribution, the company will suffer a loss.

A good way to present these options to employees is to explain how they’ll be paying for many of these medical and dependent care expenses with after-tax dollars. Section 125 cafeteria plans allow employees to save money on life necessities by paying for them with pretax dollars. 

Read more: Onboarding Best Practices

Frequently asked questions about cafeteria benefits plans

Use the following commonly asked questions to learn more about cafeteria-style plans:

What exactly is needed to qualify as a cafeteria plan?

To qualify as a cafeteria plan, it must have at least one taxable benefit option and one qualified pretax benefit. Qualified benefits include accident and health benefits, adoption assistance, dependent care assistance, group-term life insurance coverage or health savings accounts.

Can married couples both apply for DCAP or dependent care FSAs?

Dependent care accounts have a maximum of $5,000 per year per family. If both parents work, their combined contribution cannot exceed $5,000.

How do cafeteria-style plans help with retirement?

Employees can use the money saved by using FSAs to invest in retirement plans. The tax savings earned can allow more money to be deposited into an employee’s 401(k) account.

Is a cafeteria plan worth it?

Deciding if a cafeteria plan is the best option for your company requires you to look at the full situation. You gain tax benefits and can improve employee satisfaction, but it can be a complex system to administer. It can also cost you money upfront. Look at the pros and cons and work with a benefits administrator to evaluate your situation and help you decide what’s best.