Section 125 cafeteria plans: Your menu of workplace benefit

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What’s on your cafeteria tray?

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Remember the school cafeteria? Depending on the type of eater you were, you may have been excited or overwhelmed by the choices before you. You might feel that way again if you are a new employee or if you just received a notice from your company saying that it’s time for you to select your annual benefits. Many employers use a cafeteria plan—set up under IRS section 125 in 1978—that allows an employee to pick and choose different benefits through the use of taxable and nontaxable compensation. 

A cafeteria plan, as enacted by IRS section 125, is a package of benefits allowing you to choose which, if any, taxable or tax-exempt benefits you receive each year. Under the plan, any cost paid by your company toward your qualified benefits (see below) is not taxable to you. Each choice involves receiving “cash” (or a taxable benefit treated as cash) or a nontaxable qualified benefit. Typical cafeteria plans are set up in one of two ways (or a combination):

By using part of your salary to purchase benefits, you will lower your taxable income and pay less tax. Your employer will pay less in FICA and unemployment taxes, as your benefits will be deducted from your salary before taxes are calculated.

The IRS has specific rules about benefits that qualify as tax-exempt under a cafeteria plan. Typically, benefits are to be used for the employee, their spouse, and dependents under age 27. Pretax contributions will be noted on your pay stub and W-2, but will not be included in taxable income. According to the IRS, the following benefits qualify:

Although some of the benefits below are also exempt from taxes with various rules and restrictions, they are not included as part of a cafeteria plan. IRS Pub 15-B has details.

Employers have an annual open enrollment period during which the upcoming year’s benefits are offered. An employee must make choices about benefits during this enrollment period, and those choices are followed for the entire year unless a qualifying life event occurs and proof is provided to the employer. Qualifying events, which are spelled out by the IRS, include:

Because cafeteria plans involve both taxable and nontaxable items, it is sometimes confusing to understand them. Here are examples of typical ways that cafeteria plans are structured.

Jim, who works for ABC Corporation, has a salary of $140,000 paid over 24 pay periods, or $5,833 per pay period. He chooses to sign up for health insurance for his family at a cost of $20,000 per year, or $833.33 per paycheck. Because the health insurance is tax deductible, Jim’s taxable income per pay period is ($5,833 - $833) = $5,000, and ABC pays its portion of FICA and unemployment taxes on $5,000 per pay period.

Brenda, who works for JKL Corporation, has a salary of $150,000 paid over 24 pay periods, or $6,250 per pay period. JKL pays for the cost of her health insurance, which is $350 per paycheck ($8,400 per year). Her salary of $6,250 per pay period is taxable to her, and JKL pays its portion of FICA and unemployment taxes on $6,250 per pay period. Note that the $8,400 per year of health insurance cost paid by JKL is not taxable to her nor to JKL.

Dylan, who works for XYZ Corporation, has a salary of $120,000 paid over 24 pay periods, or $5,000 per pay period. XYZ charges $500 per paycheck for health insurance if the employee chooses to accept the benefit. Dylan, however, is covered under their spouse’s health insurance plan and doesn’t need health insurance through XYZ. Their full salary of $5,000 per pay period is taxable, and XYZ pays its portion of FICA and unemployment taxes on $5,000 per pay period.

Sam, who works for PRQ Corporation, has a salary of $80,000 paid over 24 pay periods, or $3,333.33 per pay period. His company offers to pay the entire cost of his health insurance, but Sam is on his spouse’s plan. PRQ pays a bonus of $4,000 per year ($166.67 per paycheck) to people who decline the health insurance benefit. Sam’s taxable income per pay period is ($3,333.33 + $166.67) = $3,500, and PRQ pays its portion of FICA and unemployment taxes on $3,500 per pay period.

When your company offers an open enrollment period for benefits selection, make sure you do some research. Understand the types of benefits, such as health insurance, vision insurance, dental insurance, and so on, that are offered. Remember that qualified cafeteria plan benefits paid by your company are not taxable to you. And when you “buy” benefits during open enrollment, your taxable income will be reduced by the amount you pay in benefits. 

When you go to lunch at a cafeteria, you should only buy what you plan to eat. Sign up for benefits the same way by only buying the benefits that you really need. Every pretax dollar you spend on benefits lowers your tax bill—but it still comes out of your paycheck. Just like at the cafeteria, you’re still paying—you’re just choosing where the money goes. Reducing your taxable income doesn’t make it free.