What Is a Cafeteria Health Plan & How Does It Work?

A cafeteria health plan offers employees a flexible way to manage their benefits. These plans enable employees to allocate a portion of their salary to specific benefits before taxes are applied. This design provides participants greater control over their benefit package and can increase their take-home pay. The appeal of such plans lies in their ability to customize benefits, accommodating diverse personal and family circumstances.

What a Cafeteria Plan Is

A cafeteria plan is an employer-sponsored benefit program enabling employees to choose between taxable cash compensation or qualified benefits. Rooted in Section 125 of the Internal Revenue Code, the term “cafeteria plan” reflects the idea that employees select from a menu of benefits, much like choosing items in a cafeteria.

Employees can elect to reduce their taxable salary to pay for eligible benefits on a pre-tax basis. Money allocated to qualified benefits is not subject to federal, state, or local income taxes when deducted from pay. These options offer tax advantages to both the employee and the employer.

Key Components of a Cafeteria Plan

Within a cafeteria plan, several common components are offered for managing healthcare and dependent care expenses.

Premium Only Plan (POP)

A Premium Only Plan (POP) allows employees to pay their portion of employer-sponsored health, dental, and vision insurance premiums with pre-tax dollars.

Flexible Spending Accounts (FSAs)

Flexible Spending Accounts (FSAs) enable employees to set aside pre-tax money for specific eligible expenses. A Health FSA covers medical, dental, and vision expenses not reimbursed by insurance, such as deductibles and co-payments. For 2025, the annual contribution limit for a Health FSA is $3,300, and plans may allow a carryover of up to $660 of unused funds. A Dependent Care FSA assists with expenses for a qualifying dependent, such as childcare for children under 13, allowing the employee to work, with a 2025 contribution limit of $5,000 for individuals or married couples filing jointly, or $2,500 if married filing separately. FSAs generally follow a “use-it-or-lose-it” rule, where funds must be used by the end of the plan year or within a grace period, with limited exceptions like the carryover.

Health Savings Accounts (HSAs)

Health Savings Accounts (HSAs) are often paired with high-deductible health plans (HDHPs) and allow for tax-deductible contributions, tax-free growth, and tax-free withdrawals for qualified medical expenses. For 2025, the maximum contribution for self-only HDHP coverage is $4,300, and for family coverage, it is $8,550, with an additional $1,000 catch-up contribution permitted for those age 55 and older. To qualify for an HSA, an HDHP must have a minimum annual deductible of $1,650 for self-only coverage or $3,300 for family coverage in 2025. Unlike FSAs, HSA funds are portable and roll over year to year.

Health Reimbursement Arrangements (HRAs)

Health Reimbursement Arrangements (HRAs) are employer-funded accounts used to reimburse employees for medical expenses. Unlike HSAs, HRAs are owned by the employer. An Excepted Benefit HRA (EBHRA) can provide a maximum benefit amount of $2,150 in 2025, helping employees with out-of-pocket healthcare costs.

How Employees Make Selections

Employee participation in a cafeteria plan begins with an annual enrollment period. During this time, employees review the available benefit options and decide which ones best suit their circumstances for the upcoming plan year. Selections generally become binding for the entire plan year.

Once elections are made, employees enter into a salary reduction agreement with their employer. This agreement authorizes the employer to deduct pre-tax contributions directly from the employee’s paychecks to fund the chosen benefits.

The Internal Revenue Service (IRS) permits changes outside of the annual enrollment period if a “qualifying life event” (QLE) occurs. Any mid-year changes must be consistent with the qualifying event. Employees usually have a limited timeframe, often 30 to 60 days from the date of the QLE, to notify their employer and make the necessary benefit adjustments.

Qualifying Life Events (QLEs)

Changes in legal marital status like marriage or divorce.
Changes in the number of dependents through birth or adoption.
A change in employment status for the employee or their spouse.
Significant changes in the cost or coverage of existing benefits.
Gaining or losing eligibility for Medicare or Medicaid.

Tax Benefits for Participants

A primary advantage of a cafeteria plan is the significant tax savings for employees. Contributions made through salary reduction agreements are deducted from an employee’s gross pay before federal income taxes are calculated. This pre-tax treatment reduces the employee’s taxable income, leading to a lower overall tax liability.

These pre-tax deductions also reduce wages subject to Federal Insurance Contributions Act (FICA) taxes. FICA taxes include Social Security and Medicare taxes. For 2025, the Social Security tax rate is 6.2% on earnings up to $176,100, and the Medicare tax rate is 1.45% on all earnings. Employers also benefit from reduced payroll taxes, as they match the employee’s FICA contributions.

Reimbursements for qualified expenses from Flexible Spending Accounts (FSAs), Health Reimbursement Arrangements (HRAs), and Health Savings Accounts (HSAs) are tax-free. For HSAs, this offers a “triple tax advantage”: contributions are tax-deductible, the funds grow tax-free, and withdrawals for qualified medical expenses are also tax-free. Money used for eligible healthcare and dependent care expenses through a cafeteria plan is never taxed.