Cafeteria Plan: Definition and Typical Options for Employees

What Is a Cafeteria Plan?

A cafeteria plan is an employee benefit plan that allows staff to choose from a variety of pre-tax benefits. You can contribute a portion of your gross income before any taxes are calculated and deducted. Plans normally include options such as insurance benefits and benefits that help with various life events such as adoption. A cafeteria plan is also referred to as a flexible benefits plan or Section 125 plan.

How Cafeteria Plans Work

A cafeteria plan gets its name from a cafeteria but has nothing to do with food. Just as individuals make food selections in a cafeteria, employees can choose the benefits of their choice before payroll taxes are calculated from a pool of options offered by their employers. These plans become more useful as diversity within workforces continues to grow and employees seek personalized benefits that are tailored to their needs.

Cafeteria plan selections include insurance options, such as health savings accounts (HSAs), group term life insurance, and disability insurance. Other popular selections include adoption assistance plans, flexible spending accounts, and cash benefits.

Flexible plan selections allow employees to tailor a cafeteria plan to their specific needs. For example, the best selection for an employee retiring may be able to make contributions to his or her 401(k) plan, while an employee with a large family may be better suited to a health plan with broad coverage.

Section 125 of the Internal Revenue Code (IRC) specifies that cafeteria plans are exempt from the calculation of gross income for federal income tax purposes. No federal or Social Security taxes are deducted. However, some benefits, such as group life insurance benefits that exceed $50,000 or adoption assistance benefits, require employers to withhold both Social Security and Medicare taxes.

Special Considerations

Employees must estimate how much money they are going to contribute to their cafeteria plan before the tax year begins. The elected amount of money is divided by the number of payroll periods and deducted from each paycheck for the duration of the plan.

Funds allocated but not spent by the employee were forfeited at the end of the year. For instance, John forfeited $500 if he only spent $1,500 of the $2,000 he allocated. Changes were made to allow employees to roll over up to $500 of unused funds from one year into the following year.

The individualized setup of cafeteria plans makes them more complex and time-consuming to administer. Employers must maintain constant communication with each employee about changes in the cost of benefits, their coverage, and their use of benefits.

Employees' changing circumstances may result in continual administration. This can partly be rectified by only allowing benefits to be changed periodically. For example, your company may only allow you to change your cafeteria plan benefits once a year.

Advantages and Disadvantages of Cafeteria Plans

Advantages

One of the main benefits of a cafeteria plan is the fact that it lowers your tax liability. By making pre-tax contributions to the plan, you reduce your gross income. Payroll taxes are deducted based on gross income, so the lower it is, the less tax you pay.

Employers can choose from both nontaxable and taxable benefits under cafeteria plans. Nontaxable benefits such as insurance options and retirement contributions are considered nontaxable options. These allow the employee to contribute to these plans without incurring any tax penalties—a major benefit and advantage for an employee's bottom line.

Disadvantages

There are drawbacks to cafeteria plans. According to the IRS, plan holders "must be permitted to choose among at least one taxable benefit (such as cash) and one qualified benefit." This means that the taxable benefit will trigger a tax liability for the tax year on the amount of the taxable benefit received.

Another drawback to cafeteria plans is their complexity. Because plans are not standard from employee to employee, they can take a lot of time to maintain and administer. This can increase costs for employers.

Employees who exceed their allocated spending amount pay a partial premium to their employer. So if Emma spends $1,000 over her allocated contribution, she pays a portion of that amount herself.

Cafeteria Plans and Flexible Spending Accounts (FSAs)

The rules for a flexible spending account (FSA) differ slightly from the "use it or lose it" rules that apply to other cafeteria plan benefits. Employers are allowed to establish a grace period for their FSA, or extra time beyond the end of the year. This allows you to spend the money from your FSA so you don't lose the funds. Alternatively, employers can offer unused contributions to carry over into the following year's plan.

Cafeteria plans must also establish a limit for the size of contributions that you can make to an FSA that is part of a cafeteria plan. If there is no limit, the FSA isn't considered part of a cafeteria plan, and all the benefits included in the plan are considered part of your taxable income. In 2023, this limit is $3,050. This limit increases to $3,200 in 2024.

The Bottom Line

Cafeteria plans allow employees to choose their benefits from a pool of options. These options can include things like 401(k)s, HSAs, FSAs, life insurance, disability insurance, adoption assistance, cash benefits, and more.

Employees estimate how much they want to contribute to the cafeteria plan before the beginning of the tax year. This amount is divided by the number of payroll periods and subtracted from each paycheck. The money that is subtracted is pre-tax, meaning employees don't have to pay tax on it. But in most cases, if they don't use the money set aside before the end of the year, it is forfeited.