26 Feb What is a Cafeteria Plan? (Also Known as a Section 125 Plan)
What is a Cafeteria Plan?
A Cafeteria Plan, also referred to as a Section 125 Plan, is a type of employee benefits plan that allows workers to choose from a variety of pre-tax benefit options. These plans are named after Section 125 of the Internal Revenue Code, which governs their tax treatment. By offering a cafeteria plan, employers can help employees save on taxes while also reducing their own payroll tax liabilities.
How Does a Cafeteria Plan Work?
A cafeteria plan functions by allowing employees to allocate a portion of their pre-tax earnings toward eligible benefits. Since these contributions are deducted before taxes, employees can lower their taxable income, increasing their take-home pay. Employers also benefit by reducing their payroll tax obligations.
Common Benefits Offered in a Cafeteria Plan
Health Insurance Premiums – Employees can pay for medical, dental, and vision insurance with pre-tax dollars.
Health Savings Accounts (HSA) and Flexible Spending Accounts (FSA) – Pre-tax contributions for healthcare expenses.
Dependent Care Assistance – Funds allocated for child or elder care services.
Group Life and Disability Insurance – Limited tax-free coverage options.
Types of Cafeteria Plans
Cafeteria plans come in different forms, each designed to suit varying business needs and compliance requirements:
Premium-Only Plan (POP) – Allows employees to pay insurance premiums with pre-tax dollars.
Full Flex Plan – Offers multiple benefit options that employees can customize.
Simple Cafeteria Plans – Designed for small businesses with fewer regulatory burdens.
Benefits of a Section 125 Cafeteria Plan
For Employees
Increased Take-Home Pay – Contributions are made pre-tax, lowering taxable income.
Customizable Benefits – Employees can select the benefits that suit their personal needs.
Reduced Out-of-Pocket Costs – Pre-tax savings on essential benefits.
For Employers
Payroll Tax Savings – Employers save on FICA and unemployment taxes.
Improved Employee Retention – Attractive benefits lead to higher job satisfaction.
Competitive Advantage – Helps small businesses offer robust benefits comparable to larger companies.
Section 125 Plan Compliance Rules
To maintain IRS compliance, cafeteria plans must:
Offer benefits exclusively for employees.
Provide a written plan document detailing options.
Avoid discrimination in favor of highly compensated employees.
Be administered correctly to prevent tax penalties.
Common Pitfalls and How to Avoid Them
Non-Compliance with IRS Rules – Ensure proper plan documentation and adherence to eligibility requirements.
Failure to Conduct Non-Discrimination Testing – Perform annual tests to confirm fairness among employees.
Lack of Employee Education – Clearly communicate the benefits and rules of participation.
A Section 125 Cafeteria Plan is a powerful tool for both employees and employers, offering tax savings and flexible benefits. Whether you’re a business looking to enhance your compensation package or an employee seeking to maximize your paycheck, understanding how a cafeteria plan works can help you make informed decisions.
Start Saving with a Section 125 Plan Today!
Interested in implementing a Cafeteria Plan for your business? Contact The Policy Shop today to explore your options and start maximizing savings for both your company and employees.