What Is the Cafeteria Plan and How Does It Work?

A cafeteria plan offers employees a structured approach to receive certain benefits through their employer. It allows individuals to tailor their benefit selections based on personal needs and circumstances. These plans provide a framework for accessing specific employee benefits in a tax-advantaged manner. Employers utilize them to offer competitive benefit packages that can attract and retain talent.

Understanding the Cafeteria Plan Concept

A cafeteria plan is defined under Internal Revenue Code Section 125. This section permits employees to choose between receiving cash or selecting from a range of qualified benefits without the chosen benefits being considered taxable income simply because cash was an alternative option. Employees can select benefits that best suit their individual or family needs from a list of options provided by their employer.

Employees electing to reduce their gross salary to pay for qualified benefits is a core principle. This pre-tax salary reduction means that the money allocated to these benefits is deducted from an employee’s pay before federal income tax, Social Security (FICA), and Medicare taxes are calculated. Consequently, an employee’s taxable income is lowered, which can result in increased take-home pay. Employers play a significant role by establishing and maintaining the written plan document, which outlines eligibility criteria, available benefits, and rules for employee participation.

Common Benefits Available

Cafeteria plans can encompass a variety of qualified benefits that employees can elect to fund with pre-tax dollars. Group health benefits are a primary offering, including medical, dental, and vision insurance premiums. Employees can use pre-tax payroll deductions to cover their portion of these insurance costs. This arrangement allows individuals to pay for essential healthcare coverage while reducing their taxable income.

Flexible Spending Accounts (FSAs) are another common component of cafeteria plans. These accounts allow employees to set aside pre-tax funds for specific eligible expenses. A Health Flexible Spending Account (Health FSA) is designed to reimburse employees for qualified medical expenses not covered by insurance, such as deductibles, co-payments, prescriptions, and certain over-the-counter medications.

A Dependent Care Flexible Spending Account (DCFSA) enables employees to pay for eligible dependent care expenses, like childcare for children under 13 or care for a disabled spouse or dependent, incurred while the employee works or seeks employment. The annual maximum contribution limit for a Health FSA for plan years beginning in 2025 is $3,300. Employees can exclude up to $5,000 of dependent care assistance from gross income each year, with a reduced limit for married individuals filing separately.

Beyond health and dependent care, cafeteria plans may also include other qualified benefits. Adoption assistance programs allow employees to set aside pre-tax money to help cover expenses related to the adoption of a child, such as agency fees, court costs, attorney fees, and travel expenses. For taxable years beginning in 2025, the maximum amount excludable from gross income for adoption assistance is $17,280. Group-term life insurance coverage is another eligible benefit, with up to $50,000 of coverage potentially paid with pre-tax contributions. Health Savings Accounts (HSAs) can also be offered within a cafeteria plan, providing a tax-advantaged savings account for those with high-deductible health plans, where funds can grow tax-free and be used for qualified medical expenses.

The Tax Savings Mechanism

Cafeteria plans deliver significant tax advantages for both employees and their employers. When an employee elects to participate in a cafeteria plan, funds are deducted from their gross pay before federal income tax, Social Security (FICA), and Medicare taxes are calculated. This reduction in gross taxable income directly lowers the amount of federal income tax an employee owes.

For example, if an employee’s annual salary is $50,000 and they contribute $3,000 to a cafeteria plan, their taxable income effectively becomes $47,000 for federal income tax purposes. This mechanism results in employees paying less in taxes, which increases their net take-home pay. Employees can save an average of 30% in federal, state, and local taxes on expenses they would otherwise pay with after-tax dollars.

Employers also realize substantial tax savings by offering a cafeteria plan. Because employee contributions to qualified benefits are made on a pre-tax basis, these amounts are not subject to the employer’s matching FICA taxes. By reducing the overall taxable payroll through cafeteria plan deductions, employers reduce their FICA tax liability. This tax reduction can be a considerable financial benefit for businesses, potentially offsetting some of the administrative costs associated with maintaining the plan. The tax savings for employers can average approximately $115 per participant in FICA payroll taxes.

Operational Aspects and Plan Variations

Cafeteria plans operate with specific rules governing employee elections and permissible changes throughout the plan year. Employees make their benefit elections annually during an open enrollment period, and these choices are generally irrevocable for the duration of the plan year.

However, the Internal Revenue Service (IRS) permits exceptions to this irrevocability rule under certain qualifying life events. These events allow employees to make mid-year changes to their benefit elections, provided the change is consistent with the event. Common qualifying life events include changes in family status, such as marriage, divorce, birth or adoption of a child, or the death of a spouse or dependent. Changes in employment status, such as a shift between full-time and part-time work or a spouse’s employment change, may also qualify.

The “use-it-or-lose-it” rule applies to Flexible Spending Accounts (FSAs), meaning unused funds remaining at year-end are generally forfeited. To provide some flexibility, employers may offer either a grace period or a limited rollover option. A grace period allows participants an additional 2.5 months after the end of the plan year to incur eligible expenses and use remaining FSA funds. Alternatively, employers may permit a limited amount of unused Health FSA funds to be rolled over into the next plan year, with the maximum rollover amount being $660 for plan years ending in 2025. Employers can offer either a grace period or a rollover, but not both.

Cafeteria plans can be structured in various ways, with two common types being Premium-Only Plans (POPs) and Full Flexible Spending Plans. A Premium-Only Plan is the simplest form of a cafeteria plan, allowing employees to pay their share of group health insurance premiums (medical, dental, vision) with pre-tax dollars. In contrast, a Full Flexible Spending Plan, also known as a full flex cafeteria plan, offers a broader selection of benefits beyond just premiums. These plans typically include options like Health FSAs and Dependent Care FSAs, providing employees with a more comprehensive menu of pre-tax benefit choices.