A Guide to Section 125 (“Cafeteria”) Plans

A cafeteria plan – also known as a Section 125 plan, after the portion of the IRS code that regulates the plans – lets employees redirect part of their salaries and wages to pay for certain benefits. Section 125 plans let employees use pre-tax dollars for these benefits, which include health and life insurance.

A financial advisor can help optimize your financial plan to mitigate your tax liability.

Cafeteria Plan Advantages

The big benefit of a cafeteria plan is a reduced tax hit. By funding the plan with pre-tax dollars, it reduces an employee’s taxable income and thus the amount they lose to taxes. (In this respect, it’s similar to a 401(k) or FSA account.) Money directed into the plan is free from federal income tax, as well as Social Security and Medicare (FICA) taxes.

In addition to saving on taxes, these plans offer flexibility. The employee gets to select from a range of offered benefits to pay from the pre-tax account. Workers can use the earnings to pay for benefits they want and need, such as health and life insurance, medical costs and childcare expenses.

An important feature of cafeteria plans is that the employee has to be able to choose not to contribute to the plan. Instead, he or she can elect to receive the money as income. With conventional employer-paid health insurance, an employee who doesn’t use the plan is getting no benefit from it. (This might happen if a spouse already has family coverage through another job.) A cafeteria plan lets such employees turn an unused benefit into cash – though, of course, that part of the worker’s wages or salary would be subject to taxes.

The plans save money for employers as well. That’s because the employer doesn’t have to pay the other half of the FICA tax on salary and wages put in a cafeteria plan. Smaller employers may offer these as a cheaper alternative to company-paid employee health coverage. With a cafeteria plan, employees can get tax-advantaged dollars to pay for their own insurance.

Allowable Benefits

Only certain benefits qualify for tax-advantaged treatment in cafeteria plans. Allowed qualified benefits include:

• Health insurance
• Accident insurance
• Adoption assistance
• Dependent care assistance
• Group term life insurance
• Health savings accounts

Note that cafeteria plans have to include at least one taxable benefit as an option for employees to choose. For instance, one such option would be the choice to use plan contributions to purchase a taxable benefit like a fitness club membership.

If an employee chooses a non-qualified benefit, whatever money is used to pay for the benefit is taxed as salary at the employee’s usual rate. And, of course, if the employee receives cash instead of a qualified benefit, he or she has to pay taxes on that as income as well.

Cafeteria Plan Requirements

The rules in IRS Section 125 require each cafeteria plan to be governed by a written plan document. Plans are only allowed to offer certain benefits. Plans have to pass non-discrimination tests and follow compliance rules about things like notifications.

Rules allow for several types of cafeteria plans. Two common ones are premium-only (POP) plans and flexible spending account (FSA) plans.

A POP plan lets an employer set aside part of worker’s pretax earnings specifically to pay for health insurance premiums. POP plans are simpler to setup and operate.

FSA plans let an employ pay for medical bills pretax. They are similar to savings accounts that can be used for medical expenses that aren’t covered by insurance.

Cafeteria Plan Limits

If you are covered by a cafeteria plan, you can only choose which benefits you will use once per year. There are exceptions, but generally you have to wait until the next plan year to change.

The many rules surrounding cafeteria plans can make them hard to administer, especially for small employers. But their low cost may make it worth the trouble. Companies that want to offer these plans can get assistance from a payroll service, professional employer organization (PEO) or insurance broker. With their help, employers can use Section 125 plans to affordably offer employees desirable benefits like health insurance and childcare assistance.

Bottom Line

Cafeteria plans (also known as Section 125 plans) are a type of benefit some companies offer to their employees. These employees set aside money, pre-tax, and spend it on a  number of different benefits. Benefits include health insurance, accident insurance, adoption assistance and group term life insurance.

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