What Is A Cafeteria Plan (IRS Section 125)?

A cafeteria plan (also referred to as “Section 125” of the IRS code) is a type of voluntary health benefit offered to employees that allows them to contribute pretax dollars into an account that can be used for qualified expenses. Businesses that offer a cafeteria plan to employees under Section 125 must provide at least two options, which must include an option for a cash benefit and an option for a qualified benefit. The end result of well-designed cafeteria plan is that employees enjoy the benefits of higher take-home pay, while employers get reduced tax liability.

Click here (PDF) for more information about Section 125 plans and how they can benefit both employees and employers.

A cash benefit is generally offered in the form of a payroll deduction (sometimes called a payroll redirection) under cafeteria plans. What this means is that payment for insurance premiums, generally under a group employee plan, are paid from pretax fund directly form the employees paycheck. While the employee does not actually receive cash through a payroll redirection agreement, the benefits are realized through a higher net paycheck and reduced health care costs. These types of plans are most frequently called POP or Premium Only Plans.

The other major option offered under Cafeteria Plans are Flex Spending Arrangements (FSA). An FSA can be used, also with pretax earnings, to reimburse workers for qualified out-of-pocket expenses that are not covered by another form of benefit. Similar to a Premium Only Plan, an FSA also offers significant savings to employees because the funds used are untaxed. Here are some of the main qualified expenses that fall under a Flex Spending Arrangement:

• Prescription and over-the-counter drugs
• Contacts and glasses
• Deductibles and copays
• Out-of-pocket expenses
• Dependent care
• Psychiatric care
• Chiropractic services
• Qualified long term medical care
• Non-cosmetic dental procedures
• Laboratory an X-ray services
• Child and dependent care

How Businesses Benefit By Offering Cafeteria Plans

With a Cafeteria Plan, the savings realized by employees can range from 15% to 40% in deductions since the funds contributed are not subject to taxes. Employers save money with a Premium Only Plan (POP) because the pretax dollars contributed by employees are not subject to payroll taxes such as Social Security and Medicare. Premium Only Plans operate as a payroll deduction plan so that the funds for the plan are taken directly from the employee’s paycheck during each pay period.

A Flex Spending Account offers the same benefits to employers as a Premium Only Plan in the form of reduced taxes. For employees, the savings are more or less the same as well, but the funds must be used for out-of-pocket expenses, rather than paying toward premiums. An FSA is a great option for employees that have regular, predictable health care costs on a year-to-year basis that may not be entirely covered by other benefits. By offering a cafeteria plan to employees, they have more choice in how their benefits are arranged and can choose the option that makes the most financial sense for them.