What Is Cafe 125 on a W2 and How Does It Work?

A Section 125 plan, commonly known as a “cafeteria plan,” is an employer-sponsored benefit program designed to offer employees a choice between receiving cash salary or selecting certain qualified benefits on a pre-tax basis. This arrangement allows employees to fund specific benefits with money deducted from their gross pay before taxes are calculated. The fundamental purpose of these plans is to provide a tax-advantaged way for employees to pay for benefits, thereby reducing their overall taxable income. By participating, employees can effectively increase their take-home pay while securing coverage for important services.

Understanding Section 125 Plans

“Cafe 125” is an informal reference to an IRS Section 125 Cafeteria Plan, which derives its name from Section 125 of the Internal Revenue Code. This type of plan allows employees to choose from a “menu” of benefits, much like a cafeteria offers various food options. Employees decide how to allocate a portion of their salary: either as taxable cash compensation or as contributions to certain non-taxable benefits. This choice distinguishes it from traditional benefit offerings.

Contributions made to qualified benefits through a Section 125 plan are on a pre-tax basis, meaning they are deducted from an employee’s paycheck before federal income tax, Social Security, and Medicare taxes are calculated. Common benefits include health insurance premiums, such as medical, dental, and vision coverage. Additionally, it can include contributions to Health Flexible Spending Accounts (FSAs), Dependent Care Flexible Spending Accounts (DCFSAs), and Health Savings Accounts (HSAs).

W2 Reporting of Section 125 Benefits

When an employee participates in a Section 125 plan, “cafe 125” is not explicitly listed as a separate box or line item on their Form W-2. Instead, its financial impact is reflected in reduced taxable wages. Pre-tax deductions for Section 125 benefits decrease the figures shown in Box 1 (Wages, Tips, Other Compensation), Box 3 (Social Security Wages), and Box 5 (Medicare Wages) of the W-2.

For instance, if an employee’s gross annual salary is $50,000 and they contribute $2,000 to health insurance premiums through a Section 125 plan, their Box 1 wages on the W-2 would be reported as $48,000. While the specific amount deducted for Section 125 benefits might appear in Box 14 of the W-2, often labeled “IRC 125,” the primary effect is the lower taxable wage figures in Boxes 1, 3, and 5.

Impact on Take-Home Pay and Taxable Income

The pre-tax nature of Section 125 plan deductions offers a financial advantage to employees, directly influencing their take-home pay and overall tax liability. Contributions to these plans result in lower federal income tax obligations, meaning employees pay less in federal income tax than if they paid for the same benefits with after-tax dollars.

The deductions also lower income subject to FICA taxes, including Social Security and Medicare taxes. This dual reduction in both income and payroll taxes leads to increased net take-home pay for the employee. Depending on their individual tax bracket and the amount contributed, employees can realize savings, potentially retaining a greater portion of their earnings.