Cafeteria Plan:
Definition, Types, Benefits & Comparison

A cafeteria plan is an employer-sponsored benefits program governed by Section 125 of the Internal Revenue Code that allows employees to choose from multiple pre-tax benefit options, including health insurance premiums, flexible spending accounts, and dependent care assistance. The plan gets its name from the concept of a cafeteria where employees select from a menu of qualified benefits, similar to choosing items from different food stations.

Cafeteria plans reduce employees' taxable income by deducting benefit contributions before taxes are calculated, which increases take-home pay while lowering the amount owed in federal income tax, Social Security tax (FICA), and Medicare tax. Employers also benefit from reduced payroll tax liabilities on FICA and Federal Unemployment Tax Act (FUTA) contributions.

To qualify as a cafeteria plan, the written plan document must allow employees to choose between at least one taxable benefit (such as cash) and one qualified non-taxable benefit. The plan cannot exist primarily to defer compensation, and it must meet specific IRS documentation, eligibility, and non-discrimination testing requirements.

Related terms: Section 125 plan, flexible benefits plan, pre-tax benefits, salary reduction agreement

A cafeteria plan operates through salary reduction agreements between the employer and employee. During open enrollment or a qualifying special enrollment period, employees elect their desired benefits and authorize pre-tax payroll deductions from their gross wages. These contributions are deducted from the employee's paycheck before federal income tax, Social Security tax, and Medicare tax are calculated, reducing the employee's taxable income.

The deducted amounts are then used to pay for the employee's chosen qualified benefits, such as health insurance premiums, contributions to flexible spending accounts for medical expenses, or dependent care assistance. Because the contributions are made with pre-tax dollars, employees effectively pay less for these benefits than they would if purchasing them with after-tax income.

Employers process payroll by first calculating gross earnings, then deducting Section 125 plan contributions, and finally withholding applicable taxes from the reduced taxable income. The employer's payroll tax liability is also reduced because the taxable wage base is lower after Section 125 deductions.

Once elections are made, they generally remain in effect for the entire plan year unless the employee experiences a qualifying life event such as marriage, divorce, birth or adoption of a child, involuntary loss of coverage, change in employment status, or a dependent aging out of coverage. Employees typically must provide documentation to prove eligibility for a mid-year election change.

There are 4 primary types of cafeteria plans:

• Premium Only Plan (POP): The most basic cafeteria plan type where employees can only use pre-tax deductions to pay for group health insurance premiums (medical, dental, vision). No other benefits such as flexible spending accounts are included.
• Full Flex Cafeteria Plan: A comprehensive plan where employees use employer contributions to purchase benefits that meet their needs and can add flexible spending accounts or health savings accounts to cover qualified medical expenses not fully covered by employer funds.
• Simple Cafeteria Plan: Designed for small employers with 100 or fewer employees. This streamlined version provides safe harbor from standard non-discrimination testing requirements if the employer meets specific contribution, eligibility, and participation requirements.
• Flexible Spending Arrangement (FSA): A form of cafeteria plan benefit funded by salary reduction that reimburses employees for expenses incurred for qualified medical care, dependent care assistance, or adoption assistance, subject to annual maximums and use-or-lose rules.

The IRS defines qualified benefits that can be included in a Section 125 cafeteria plan. These benefits do not defer compensation and are excludable from an employee's gross income under specific provisions of the Internal Revenue Code.

Qualified benefits include 6 main categories:

• Accident and health benefits: Group health insurance premiums for medical, dental, and vision coverage (excluding Archer medical savings accounts and long-term care insurance)
• Adoption assistance: Benefits to help cover adoption-related expenses
• Dependent care assistance: Programs that reimburse employees for care of children under 13 or elderly dependents, up to $5,000 annually ($2,500 for married filing separately)
• Group-term life insurance coverage: Premiums for group-term life insurance, though coverage exceeding $50,000 is subject to Social Security and Medicare taxes
• Health savings accounts (HSAs): Tax-advantaged accounts for employees with high-deductible health plans, including distributions to pay long-term care services
• Flexible spending accounts (FSAs): Accounts allowing pre-tax contributions up to $3,300 (2025 limit) to reimburse qualified out-of-pocket medical expenses

Benefits that do not qualify under Section 125 include long-term care insurance, tuition assistance, employee discount programs, work cell phones, moving expenses, commuter benefits, gym memberships, and minimal or de minimis benefits. These benefits may still be offered by employers but cannot be paid for with pre-tax dollars through a cafeteria plan.

Cafeteria plans can make benefits available to employees, their spouses, and dependents. The plan may also include coverage of former employees but cannot exist primarily for them. Generally, any employer with employees subject to U.S. income taxes can sponsor a cafeteria plan, including sole proprietorships, partnerships, limited liability companies (LLCs), C corporations, S corporations, and government entities.

However, certain individuals are specifically excluded from participating as employees under IRS rules. Self-employed individuals, partners in a partnership, and shareholders who own more than 2% of an S corporation cannot participate in cafeteria plans as employees, though they can sponsor plans for their eligible employees.

Domestic partners and their children may benefit from an employee's cafeteria plan selections (such as family medical insurance coverage or dependent care assistance), but they cannot be direct participants with their own election rights because they are not employees of the sponsoring employer.

Cafeteria plans provide significant tax advantages for both employees and employers. For employees, salary reduction contributions made through a cafeteria plan are not considered wages for federal income tax purposes and are generally exempt from Social Security tax (FICA) and Medicare tax. This reduces the employee's taxable income, resulting in lower overall tax liability and increased take-home pay.

For employers, the tax benefits come from reduced payroll tax obligations. Because employee contributions to cafeteria plans reduce the taxable wage base, employers pay less in their share of FICA taxes (Social Security and Medicare), Federal Unemployment Tax Act (FUTA) taxes, and applicable state unemployment taxes. These savings can amount to approximately 7% of the contributed payroll costs.

For example, if an employee contributes $100 per paycheck to a cafeteria plan, their taxable income is reduced by $100. If the employee is in the 25% tax bracket, they save $25 in federal income tax plus additional savings on FICA taxes. The employer simultaneously saves on their portion of payroll taxes on that $100.

There are specific exceptions to these tax advantages. Group-term life insurance coverage exceeding $50,000 remains subject to Social Security and Medicare taxes (but not FUTA or income tax withholding) even when provided through a cafeteria plan. Adoption assistance benefits are subject to Social Security, Medicare, and FUTA taxes but not income tax withholding. Any cash benefits elected by employees instead of qualified benefits are treated as regular wages subject to all employment taxes.

Cafeteria plans must meet specific IRS compliance requirements outlined in Section 125 of the Internal Revenue Code. The plan must be maintained under a written plan document that describes all benefits, establishes rules for eligibility and elections, and outlines procedures for making or changing benefit selections.

Cafeteria plans must undergo 3 types of annual non-discrimination testing to ensure they do not favor highly compensated employees or key employees:

1. Eligibility Test: Verifies the plan is available broadly and fairly to all eligible employees using consistent eligibility criteria, with any waiting period limited to three years or less
2. Contributions and Benefits Test: Ensures contributions and benefits for highly compensated employees are proportionally equal to or less favorable than those for non-highly compensated employees
3. Key Employee Concentration Test: Confirms that no more than 25% of total pre-tax benefits are allocated to key employees (defined by factors such as ownership stakes or specified compensation levels)

If a cafeteria plan discriminates in favor of highly compensated employees, those employees must report their cafeteria plan benefits as taxable income. Similarly, if statutory non-taxable benefits provided to key employees exceed 25% of aggregate benefits provided to all employees, key employees must report their benefits as income.

Most cafeteria plans are covered by the Employee Retirement Income Security Act (ERISA) and must meet documentation, reporting, and administrative requirements. Employers must maintain a main plan document, adoption agreement, and summary plan description (SPD) that is distributed to eligible employees within 90 days of enrollment and refreshed approximately every five years.

Filing requirements vary depending on whether the plan offers welfare benefits. Employers may need to file Form 5500 with the U.S. Department of Labor annually. Generally, cafeteria plans themselves do not require Form 5500 filing unless they include a welfare benefit plan subject to Department of Labor regulations.

The use-it-or-lose-it rule is an IRS requirement stipulating that participants in flexible spending accounts must spend their entire account balance on qualified expenses by the end of the plan year, or they will forfeit any remaining funds. This rule prevents employees from accumulating FSA balances year after year and ensures that the accounts are used for their intended purpose of covering current-year expenses.

To help employees avoid losing unused funds, the IRS provides employers with two options. First, employers may offer a grace period of up to 2.5 months after the plan year ends, allowing employees to incur and submit claims for qualified expenses using the previous year's FSA funds. Second, employers may allow a limited carryover provision that permits employees to carry over a specified amount (up to $640 for 2025) of unused FSA funds to the following plan year.

Employers can choose to offer either the grace period or the carryover option, but not both simultaneously. Employees should carefully estimate their annual expenses when electing FSA contributions to minimize the risk of forfeiting unused funds.

Once employees enroll in a cafeteria plan and make their benefit elections, they generally cannot change those elections until the next open enrollment period unless they experience a qualifying life event. This restriction ensures that employees make considered choices and prevents adverse selection that could destabilize the benefit pool.

Qualifying life events that permit mid-year election changes include marriage, divorce, legal separation, birth or adoption of a child, involuntary loss of coverage under another plan, change in employment status (for the employee, spouse, or dependent), and a dependent aging out of a parent's plan. The change in election must be consistent with the qualifying event.

Employees typically have 30 to 60 days after the qualifying event to request an election change and must provide documentation such as a marriage license, birth certificate, or letter from an insurance company to prove their eligibility for the special enrollment period.

To set up a Section 125 cafeteria plan, employers must first draft a written plan document that outlines the benefits offered, contribution limits, participation rules, eligibility requirements, and other information required by the IRS. This document serves as the legal foundation of the plan and must be reviewed by legal counsel to ensure compliance with all applicable regulations.

Employers must also prepare an adoption agreement (often included as part of the main plan document) formally documenting that the employer has adopted the Section 125 benefit plan. A summary plan description (SPD) must be created and distributed to all eligible employees within 90 days of enrollment, providing an abridged, employee-friendly version of the main plan document.

Many employers enlist the help of a third-party administrator to set up and manage their cafeteria plan due to the complexity of documentation requirements, non-discrimination testing, claims processing, and ongoing compliance obligations. Third-party administrators often provide integrated benefits administration tools that connect with HR and payroll systems to ensure accurate deductions, tax calculations, and reporting.

Employers must also determine which types of benefits to offer (POP, FSA, DCAP, HSA) and establish processes for open enrollment, qualifying event verification, claims submission and reimbursement, and employee communication and education about plan features.

Health flexible spending accounts allow reimbursement for qualified medical expenses as defined by IRS Publication 502. Eligible expenses must be primarily for medical care and can include a wide range of services and products that alleviate or treat personal injuries or sickness.

Common eligible expenses include acupuncture, ambulance services, birth control pills, chiropractic care, contact lenses and cleaning solution, dental fees and dentures, diagnostic fees, doctor fees, eye exams and glasses, fertility enhancement, hearing aids, hospital care, insulin, lab fees, laser eye surgery, nursing home care for medical reasons, orthodontia, orthopedic shoes, prescription drugs, psychiatric care, stop-smoking programs and prescription drugs, wheelchairs, and X-rays.

Over-the-counter medicines and drugs are eligible for reimbursement only with a written recommendation from a physician. Eligible over-the-counter items include allergy medicine, antacids, anti-diarrhea medicine, bandages, cold medicines, contact lens solution, cough drops, first aid kits, pain relievers, pregnancy test kits, reading glasses, sunburn ointments, thermometers, and throat lozenges.

Certain dual-purpose items can be reimbursed if used for medical purposes and accompanied by a medical practitioner's note stating the item treats a specific medical condition rather than serving a cosmetic purpose. Examples include acne treatment for acne vulgaris, dietary supplements or herbal medicines for specific medical conditions, glucosamine/chondroitin for arthritis, hormone therapy for menopause symptoms, prenatal vitamins, and weight-loss drugs to treat obesity.

Expenses that are not eligible for reimbursement include cosmetic surgery (unless medically necessary), over-the-counter drugs without a physician's recommendation, health insurance premiums paid with pre-tax dollars through a premium-only plan, and expenses reimbursed by another health plan.

A cafeteria plan is a benefits program structure governed by Section 125 of the Internal Revenue Code that allows employees to choose from multiple pre-tax benefit options. A health savings account (HSA) is a specific type of tax-advantaged savings account that can be offered as one of the qualified benefits within a cafeteria plan.

The key distinction is that a cafeteria plan is the overarching framework or delivery mechanism for offering various benefits on a pre-tax basis, while an HSA is a particular savings vehicle available only to employees enrolled in high-deductible health plans. An HSA allows employees to contribute pre-tax dollars (up to annual IRS limits) to an account that can be used for qualified medical expenses, including distributions to pay long-term care services.

Unlike flexible spending accounts, HSAs do not have a use-it-or-lose-it rule. Unused HSA funds roll over year after year and remain with the employee even if they change employers or retire. HSA contributions, earnings, and qualified withdrawals are all tax-free, providing a triple tax advantage.

A cafeteria plan can include an HSA as one of several benefit options alongside health insurance premiums, flexible spending accounts, dependent care assistance, and other qualified benefits. Employees enrolled in a high-deductible health plan through the cafeteria plan may choose to contribute to an HSA, while those with traditional health plans might opt for a flexible spending account instead.

A cafeteria plan is often compared to 3 related employee benefit structures:

Cafeteria Plan vs. Traditional Group Health Plan

A traditional group health plan provides health insurance coverage to employees, typically with employees paying their share of premiums through after-tax payroll deductions. A cafeteria plan enhances this structure by allowing employees to pay their portion of health insurance premiums with pre-tax dollars, reducing taxable income. Additionally, cafeteria plans offer choices beyond health insurance, such as flexible spending accounts, dependent care assistance, and health savings accounts, giving employees flexibility to customize their benefits package based on individual needs.

Cafeteria Plan vs. Health Reimbursement Arrangement (HRA)

A health reimbursement arrangement is an employer-funded benefit plan that reimburses employees for qualified medical expenses and, in some cases, insurance premiums. HRAs are not funded by employee salary reductions and are not considered cafeteria plans under Section 125. The employer determines the reimbursement amounts and eligible expenses. In contrast, a cafeteria plan is funded through employee pre-tax salary reductions and offers employees the ability to choose from multiple qualified benefits. Cafeteria plans can include HRA-like features through flexible spending accounts, but the funding source and level of employee choice differ significantly.

Cafeteria Plan vs. 401(k) Retirement Plan

A 401(k) plan is a retirement benefit governed by Section 401(k) of the Internal Revenue Code that allows employees to make pre-tax salary deferrals for long-term retirement savings, often with employer matching contributions. A cafeteria plan under Section 125 focuses on current-year health, dependent care, and insurance benefits rather than retirement savings. While both allow pre-tax contributions that reduce taxable income, 401(k) contributions are intended for post-retirement use with penalties for early withdrawal, whereas cafeteria plan benefits must be used for eligible expenses within the plan year or grace period. The IRS explicitly excludes deferred compensation plans like 401(k)s from qualifying as cafeteria plans.