What Does a Cafeteria Plan Mean for Employee Benefits?

Understanding the Core Concept

A cafeteria plan, formally recognized under Internal Revenue Code Section 125, enables employees to choose between receiving cash compensation or selecting certain qualified benefits. This structure offers a significant advantage by allowing employees to pay for their chosen benefits with pre-tax dollars. The fundamental idea centers on providing flexibility, allowing individuals to tailor their benefits package to their specific needs and circumstances.

Contributions made through a cafeteria plan are typically deducted from an employee’s gross pay before federal, state, and Federal Insurance Contributions Act (FICA) taxes are calculated. This pre-tax treatment effectively reduces the employee’s taxable income, leading to lower overall tax liability. For instance, a portion of an employee’s wages is redirected to cover benefit costs before income tax withholding, which includes Social Security and Medicare taxes, is applied. This reduction in taxable income represents a direct financial benefit to participating employees.

By lowering an employee’s taxable income, a cafeteria plan can result in a higher net take-home pay compared to purchasing the same benefits with after-tax dollars. The employer also benefits from reduced FICA tax contributions, as these taxes are based on the employee’s taxable wage. This arrangement creates a mutually beneficial scenario where employees gain tax savings, and employers can offer attractive benefits more efficiently.

Key Characteristics and Rules

Cafeteria plans operate under specific regulations, particularly concerning the timing of benefit elections and the usage of funds. A significant rule for certain benefits, such as Flexible Spending Accounts (FSAs), is the “use-it-or-lose-it” provision. This means that funds elected for a plan year must be used by the end of that year, or they are forfeited. However, employers may offer exceptions, such as a grace period of up to two and a half months into the next plan year, allowing employees extra time to incur expenses. Alternatively, some plans permit a limited carryover of unused funds, for example, up to $640 for health FSAs in 2024, into the following year.

Once an employee makes their benefit elections for a plan year, these choices are generally irrevocable. Mid-year changes to benefit elections are typically not permitted unless a specific qualifying life event occurs. These events are defined by the Internal Revenue Service and commonly include marriage, divorce, birth or adoption of a child, change in employment status for the employee or spouse, or loss of other health coverage. Such events allow an employee to adjust their benefit elections to reflect their new circumstances.

Common Benefit Options

Cafeteria plans commonly facilitate access to a range of pre-tax benefits that address various employee needs. Health insurance premiums are frequently paid through these plans, covering medical, dental, and vision care costs.

Flexible Spending Accounts (FSAs) are another popular offering, allowing employees to set aside pre-tax money for specific eligible expenses. Health FSAs cover out-of-pocket medical costs like co-pays, deductibles, and prescription medications. Dependent Care FSAs, conversely, are used for expenses related to the care of qualifying dependents, such as childcare for children under 13, enabling parents to work.

Health Savings Accounts (HSAs) can also be funded through a cafeteria plan, specifically when paired with a high-deductible health plan (HDHP). Contributions to an HSA through a cafeteria plan are pre-tax, providing a triple tax advantage: pre-tax contributions, tax-free growth, and tax-free withdrawals for qualified medical expenses. Additionally, group term life insurance premiums, up to a certain amount (e.g., the first $50,000 of coverage), and disability insurance premiums are sometimes offered as pre-tax benefits under these plans.

Employee Participation and Election

Employee participation in a cafeteria plan typically begins with an annual open enrollment period. During this designated window, usually occurring once a year, employees review the available benefit options and make their selections for the upcoming plan year. This is the opportunity to choose which benefits to enroll in and, for accounts like FSAs, to determine the annual contribution amount.

Once elections are finalized, the agreed-upon pre-tax contributions are deducted directly from the employee’s regular paychecks. These deductions are typically spread evenly across the pay periods within the plan year. For instance, if an employee elects to contribute $2,400 to a health FSA for the year and is paid bi-weekly, $100 would be deducted from each bi-weekly paycheck.