What Is a Cafeteria Plan HSA and How Does It Work?

A cafeteria plan and a Health Savings Account (HSA) are distinct financial tools that offer tax advantages for managing healthcare costs. A cafeteria plan is an employer-sponsored benefit program allowing employees to select from various benefits, often using pre-tax dollars. An HSA, in contrast, is a tax-advantaged savings account specifically designed for healthcare expenses.

Understanding Cafeteria Plans

A cafeteria plan, also known as a Section 125 plan, is an employee benefit program established under Internal Revenue Code Section 125. This plan allows employees to pay for certain qualified benefits with pre-tax dollars, which effectively reduces their taxable income.

The core function of a Section 125 plan is to enable employees to convert taxable cash compensation into non-taxable benefits. By deducting these contributions from gross pay before taxes are calculated, employees reduce their federal income tax, Social Security (FICA), and Medicare tax obligations. This results in more take-home pay, enhancing the overall value of their compensation package.

Common benefits offered through cafeteria plans include health insurance premiums, dental and vision coverage, flexible spending accounts (FSAs) for medical or dependent care, and group-term life insurance. Some cafeteria plans may also include Health Savings Account contributions. A key characteristic of some accounts within a cafeteria plan, such as FSAs, is the “use-it-or-lose-it” rule, where unspent funds typically expire at the end of the plan year.

Understanding Health Savings Accounts (HSAs)

A Health Savings Account (HSA) serves as a tax-advantaged savings account specifically designated for qualified healthcare expenses. These accounts are owned by the individual, making them portable even if employment changes.

A crucial requirement for establishing and contributing to an HSA is enrollment in a High Deductible Health Plan (HDHP). An HDHP is a health insurance plan characterized by a higher annual deductible compared to traditional plans, often with lower monthly premiums. For 2025, an HDHP must have a minimum deductible of at least $1,650 for self-only coverage or $3,300 for family coverage. The maximum out-of-pocket expenses for an HDHP in 2025 are $8,300 for self-only coverage and $16,600 for family coverage.

HSAs are often recognized for their “triple tax advantage.” This includes tax-deductible contributions, tax-free growth of the funds through interest or investments, and tax-free withdrawals for qualified medical expenses. The funds within an HSA roll over from year to year and remain available for future healthcare costs, unlike the “use-it-or-lose-it” nature of some other benefit accounts.

Integrating Cafeteria Plans and HSAs

While HSAs inherently provide tax advantages, integrating them with a cafeteria plan offers additional financial benefits, primarily through pre-tax payroll deductions. When an employer offers HSA contributions through a Section 125 cafeteria plan, employees can elect to have a portion of their gross salary directed into their HSA. This deduction occurs before federal income taxes, and importantly, before FICA taxes (Social Security and Medicare) are calculated.

This pre-tax payroll deduction mechanism provides a greater tax savings compared to making post-tax contributions to an HSA and then deducting them on a tax return. By reducing the employee’s taxable income, it lowers the amount subject to FICA taxes. Employers also benefit from reduced payroll taxes on these pre-tax contributions. The cafeteria plan functions as the administrative framework that facilitates these pre-tax contributions, streamlining the process for both employees and employers. This synergy maximizes the tax efficiency of saving for healthcare costs.

Key Rules for Contributions and Distributions

The Internal Revenue Service (IRS) sets annual limits for HSA contributions, which are subject to periodic adjustments. For 2025, individuals with self-only HDHP coverage can contribute up to $4,300, while those with family HDHP coverage can contribute up to $8,550. Individuals aged 55 and over are permitted to make an additional “catch-up” contribution of $1,000 per year. These limits apply to the total contributions from all sources, including both employee and employer contributions.

Employers can also contribute to employee HSAs, and these contributions are generally excluded from the employee’s gross income and are not subject to federal income tax, Social Security, or Medicare taxes. These employer contributions are reported on an employee’s Form W-2. If an employee contributes more than the annual limit, the excess amount may be subject to income tax and a 6% excise tax unless corrected before the tax filing deadline.

HSA funds can be withdrawn tax-free for qualified medical expenses, which include a broad range of services and products such as deductibles, co-pays, prescriptions, dental care, and vision care. IRS Publication 502 provides comprehensive guidance on what constitutes a qualified medical expense. If funds are withdrawn for non-qualified expenses before age 65, they are subject to both income tax and an additional 20% penalty.

Upon reaching age 65, the rules for HSA distributions become more flexible. While withdrawals for qualified medical expenses remain tax-free, funds can also be withdrawn for any purpose without incurring the 20% penalty. However, withdrawals for non-qualified expenses after age 65 are still subject to ordinary income tax. This flexibility allows HSAs to function similarly to traditional retirement accounts in later life.