What Is a Cafeteria Plan?
A cafeteria plan, as defined under Section 125 of the Internal Revenue Code (IRC), is an employer-provided benefit program that enables employees to select from a menu of benefit options, some of which can be paid for using pretax dollars. This structure provides both flexibility and tax advantages for eligible workers.
Understanding the Purpose of Cafeteria Plans
Employees participating in a cafeteria plan are typically offered a choice between at least one taxable option, such as receiving the equivalent value in cash, and one or more qualified benefits, like health insurance or other pre-approved perks.
To meet IRS requirements, cafeteria plans cannot include deferred compensation. Contributions made toward benefits are typically excluded from gross income, meaning they’re not subject to standard payroll taxes. This offers savings for both employees and their employers.
How Cafeteria Plans Came to Be
Although informal benefit programs existed prior to 1978, employees were required to pay tax on employer contributions. The Revenue Act of 1978 officially introduced Section 125 to the IRC, allowing certain employer and employee contributions to be non-taxable, provided they stay within legal boundaries. The result: significant payroll tax reductions for both parties.
Benefits Commonly Offered Through a Cafeteria Plan
Eligible benefits under Section 125 include:
- Group health coverage
- Dental and vision plans
- Disability insurance
- Group-term life insurance
- Health savings accounts (HSAs)
- Flexible spending accounts (FSAs)
- Dependent care assistance
- Adoption assistance
- Accidental death and dismemberment coverage
Note: Benefits like tuition reimbursement, commuter perks, or health reimbursement arrangements (HRAs) are not covered under Section 125.
What Employers Need to Know
To legally offer a cafeteria plan, businesses must:
- Prepare a formal written plan detailing the rules, benefits, eligibility criteria, and responsible parties (plan administrator and trustees).
- Provide all eligible participants with a summary plan description (SPD).
- Understand that most qualified benefits are not subject to federal income tax, Social Security, Medicare, or FUTA taxes, although state and local tax regulations may vary.
- Keep in mind: life insurance coverage over $50,000 is subject to Social Security and Medicare taxes, even under a cafeteria plan.
- Know that self-employed individuals are not eligible to participate, only common-law employees qualify.
Pros and Cons of Offering a Cafeteria Plan
Advantages:
- Reduces taxable income for both employers and employees
- Enhances your ability to attract and retain top talent
- Allows employees to personalize their benefits based on their circumstances
- Must comply with nondiscrimination rules, promoting fairness across employee levels
Disadvantages:
- Must adhere to strict regulatory requirements
- Often involves third-party administrative (TPA) fees to remain compliant
- Employees are usually locked into their benefit elections for the entire plan year
- The “use-it-or-lose-it” rule may apply – unused FSA funds might be forfeited unless carryover or grace periods are built into the plan
Legal Considerations for Cafeteria Plans
Besides following IRC Section 125, employers should be aware of other relevant legislation, including:
- ERISA (Employee Retirement Income Security Act)
- COBRA (Consolidated Omnibus Budget Reconciliation Act)
- ACA (Affordable Care Act)
- HIPAA (Health Insurance Portability and Accountability Act)
- GINA (Genetic Information Nondiscrimination Act)
- State and municipal laws related to wages, hours, and nondiscrimination
How to Communicate Cafeteria Plans Effectively
A 2023 survey by MetLife revealed that half of all employees said clearer benefits communication would increase their loyalty to their employer. That means clarity is key.
Employers should explain:
- The goal of the cafeteria plan
- How it functions in day-to-day payroll
- The benefits and potential limitations
- How employees can enroll, make changes, or ask for help
- Who to contact for more details – whether HR, Beyond, or a benefits administrator
By educating your team and offering the right tools, like Beyond, to streamline plan management, your cafeteria plan can become a strong asset in your benefits offering.