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

KEY TAKEAWAYS

• Cafeteria plans allow employees to choose from a variety of pre-tax benefits.
• These plans are often more flexible than others.
• Employees have a number of pre-tax options including insurance benefits, retirement plans, and benefits that help with life events.
• Cafeteria plans can be more complex and require more time to administer.

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 more personalized benefits that are tailored to their needs.

Cafeteria plan selections include insurance options such as health savings accounts (HSAs) contributions, group term life insurance, and disability insurance. Other popular selections include adoption assistance plans, flexible spending accounts, and cash benefits.¹

Flexible plan selections allow employees to tailor a cafeteria plan to their specific needs. For example, the best selection for an employee reaching retirement 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—like group life insurance benefits that exceed $50,000 or adoption assistance benefits—require employers to withhold both Social Security and Medicare taxes.¹

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.

Any funds allocated but not spent by the employee are forfeited.¹ For instance, if John allocates $2,000 for medical expenses but only spends $1,500, he ends up forfeiting $500. 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.

The disadvantage of a cafeteria plan is it usually takes more time to administer and is typically more complex.

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 staff to change their benefits periodically. For example, a company may only allow employees to change their cafeteria plan benefits once a year. If an employee uses the full benefit of their plan and leaves the company before they have paid their yearly contribution, the employer incurs a loss.

Advantages and Disadvantages of Cafeteria Plans

One of the main benefits of a cafeteria plan is the fact that it shaves off an individual’s tax liability. By making pre-tax contributions to the plan, employees reduce their gross income from which payroll taxes are deducted. So the lower the gross income, the lower the tax deductions. But, as mentioned above, because they involve individualized options and plans, they can take a lot of time to maintain and administer—a costly expense for employers.

Employees 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.¹

But there are drawbacks to cafeteria plans, especially if the employee chooses a taxable benefit such as cash. In cases like these, the employee will incur a tax liability for the tax year on the amount of the cash benefit received.

–Julia Kagan Investopedia