What Is a Section 125 (Cafeteria) Plan?

A Section 125 plan, often referred to as a Cafeteria Plan, is an employer-sponsored benefit program established under Section 125 of the Internal Revenue Code. This plan allows employees to choose between receiving taxable cash compensation or electing certain qualified non-taxable benefits. The primary purpose of a Section 125 plan is to enable employees to pay for their share of benefit premiums and other eligible expenses with pre-tax dollars. This pre-tax contribution reduces an employee’s taxable income, which can lead to significant tax savings.

Core Components of a Section 125 Plan

A Section 125 plan functions like a “cafeteria,” offering employees a menu of benefit options from which they can select those that best fit their individual needs. Employees can choose to allocate a portion of their gross salary, before taxes are calculated, to fund these chosen benefits. This pre-tax deduction lowers an employee’s gross income for federal income tax, Social Security (FICA), and Medicare tax purposes, and often for state and local income taxes as well.

Benefit elections made under a Section 125 plan are generally irrevocable for the duration of the plan year, which typically spans 12 months. Employees commit to their choices before the plan year begins, and these elections cannot be changed mid-year unless a specific qualifying life event occurs. Such events include changes in marital status, birth or adoption of a child, changes in employment status, or other significant life changes.

A fundamental rule governing certain accounts within a Section 125 plan, particularly Flexible Spending Accounts (FSAs), is the “use-it-or-lose-it” rule. This rule dictates that funds contributed to these accounts must generally be used by the end of the plan year or they will be forfeited.

Benefits Offered Through a Section 125 Plan

Section 125 plans can include various qualified benefits that employees can pay for on a pre-tax basis. Health Flexible Spending Accounts (Health FSAs) are common, allowing employees to set aside funds for eligible medical expenses not covered by health insurance, such as deductibles, co-payments, and prescription medications. These accounts help manage out-of-pocket healthcare costs using tax-advantaged dollars.

Dependent Care Flexible Spending Accounts (DCFSAs) are another popular option, enabling employees to pay for eligible dependent care expenses. These expenses typically include costs for childcare for children under 13, or care for a disabled spouse or elderly parent, which are necessary to allow the employee and their spouse to work. Common eligible services include daycare, preschool, and before- or after-school programs.

Health Savings Accounts (HSAs) can also be funded through a Section 125 plan, provided the employee is enrolled in a High Deductible Health Plan (HDHP). Contributions to HSAs made through a Section 125 plan are pre-tax, offering tax-free growth and tax-free withdrawals for qualified medical expenses. Additionally, employees can typically pay their share of group health, dental, and vision insurance premiums on a pre-tax basis through a Section 125 plan.

Other benefits that may be included in a Section 125 plan are group term life insurance (up to $50,000 in coverage), accident and disability coverage, and adoption assistance. However, certain benefits are not permitted, such as deferred compensation, long-term care insurance, scholarships, and employer-provided meals.

Tax Advantages of Section 125 Plans

Section 125 plans offer tax benefits for both employees and employers. For employees, contributing to these plans on a pre-tax basis directly reduces their gross taxable income. This reduction means less money is subject to federal income tax, Social Security tax (FICA), and Medicare tax, resulting in a lower overall tax liability. For example, an employee contributing $1,000 to an FSA could save between 20% and 40% in combined federal, state, and local taxes on that amount.

Employers also realize tax savings from implementing Section 125 plans. Since employee contributions are deducted before taxes, the employer’s total payroll subject to FICA taxes is reduced. This leads to a direct reduction in the employer’s share of payroll taxes. Beyond direct tax savings, offering competitive benefits through a Section 125 plan can enhance an organization’s ability to attract and retain talent in the labor market.

Key Rules for Section 125 Plans

For a Section 125 plan to be valid and receive favorable tax treatment, a formal, written plan document is legally required by the Internal Revenue Service (IRS). This document details the plan’s terms, eligibility requirements, and the specific benefits offered. Without a compliant written plan, employee elections could result in taxable income.

Section 125 plans must adhere to non-discrimination rules, which ensure that the plan does not favor highly compensated employees (HCEs) or key employees. These rules apply to eligibility, contributions, and benefits, aiming to provide equitable access and benefits across a broad range of employees. Compliance with these rules is essential to maintain the plan’s tax-advantaged status.

While the “use-it-or-lose-it” rule generally applies to FSAs, there are specific exceptions employers can choose to offer. One exception is a grace period, which allows employees up to 2.5 months after the plan year ends to incur and be reimbursed for eligible expenses from the prior year’s funds. Another exception is a carryover provision, which permits a certain amount of unused FSA funds to be carried over to the next plan year. For example, for plan years beginning in 2024, the maximum carryover limit for a health FSA is $640. A plan generally cannot offer both a grace period and a carryover; it must select one.

Employees typically make their benefit elections for the upcoming plan year during an annual enrollment period. This period allows individuals to review their anticipated needs and allocate pre-tax funds accordingly. Changes outside of this annual enrollment are only permitted under specific qualifying life events.