Section 125 of the IRS code allows employers to offer employees a choice between receiving a portion of their compensation in cash or as part of an employee benefit that can provide sizeable tax savings for both the employer and employee. A section 125 plan is also referred to as a cafeteria plan because employers can choose to sponsor a variety of benefits and employees can select the benefits that meet their need, like you would from a cafeteria of options, and pay through payroll deduction on a pre-tax basis.
Common examples of cafeteria plans include:
- Premium only Plans (POP) – With this type of plan, an employee’s pretax contributions can only be used to cover the cost of group health insurance premiums.
- Flexible Spending/Savings Arrangements (FSA) – Employees enrolled in an FSA set aside pretax dollars, which can be used to reimburse qualified medical expenses. These plans have an annual maximum contribution limit and qualified unused funds are usually lost at the end of the year.
- Dependent Care Assistance Plan (DCAP) – A flexible spending account for dependent care. $5000 maximum election per year per household with no carryover. “Use it or lose it”
The IRS considers the following to be qualified benefits under section 125:
- Group health benefits
- Accident and disability coverage
- Adoption assistance
- Dependent care assistance
- Group-term life insurance coverage
- Health savings accounts (HSA’s) – $3850 annual contribution max for individual in 2023. $7750 for families. Annual “catch-up” contribution amount for 55 and older remains at $1,000.
Health and Medical based cafeteria plans, depending on the provider, may cover a wide variety of medical services, including:
- Medical
- Dental
- Vision
- Ambulatory
- Chiropractic
- Psychiatric
Once employees enroll in a cafeteria plan and make their selections, they generally cannot change them until the next open enrollment period unless they experience a qualifying life event such as:
- Marriage, divorce, or legal separation
- Childbirth or adoption
- Involuntary loss of coverage under another plan
- Change in employment status
- Aging out of a parent’s plan
Benefits that don’t meet section 125 requirements may still be offered by employers, but they cannot be paid for with pretax dollars. Examples include but are not limited to:
- Tuition assistance
- Employee discount programs
- Work cell phones
- Moving expenses
- Commuter benefits
- Gym memberships
- Minimal or de minimis benefits (small benefits that make accounting of them unreasonable)
The overall advantage to a cafeteria plan is that the employee takes home more pay by using pre-tax dollars to pay for out-of-pocket medical expenses, dependent care, and insurance premiums. The employer benefits through a reduction on payroll taxes while providing a more competitive employee benefits package to attract and retain talent.
This material is compiled from sources SST believes to be reliable. The possibility of error does exist. The material is intended only as educational and may omit information on exceptions, qualifications, definitions, and effective dates. The reader should not rely solely on this material but should review original sources to determine the law and applicability for each situation. Neither the author nor Solid State Tax Service, LLC will be responsible for any error, omission, or inaccuracy under any circumstance.