Section 125 Cafeteria Plan
How Does a Section 125 Cafeteria Plan Reduce Taxable Income?
A Section 125 cafeteria plan is a benefits arrangement under the IRS tax code that lets employees choose from a menu of pre-tax benefit options—such as health insurance premiums, FSA contributions, and dependent care—reducing their taxable income.
Employees select from a “menu” of qualifying pre-tax benefits, and the value selected is deducted from pay before taxes are calculated, lowering both employee taxable income and the employer’s payroll tax base. Common components include health premium contributions, healthcare and dependent care FSAs, and sometimes an HSA contribution option.
Cafeteria plans must satisfy IRS nondiscrimination testing. Elections generally lock in for the plan year, changeable only during open enrollment or after a qualifying life event.
Section 125 Cafeteria Plan Key Facts and Eligible Benefits:
- Lets employees select from a menu of pre-tax benefits, reducing taxable income for both parties.
- Common components: health premium contributions, FSAs, dependent care.
- Must satisfy IRS nondiscrimination testing to maintain tax-advantaged status.
- Elections generally lock in for the plan year absent a qualifying life event.
Frequently Asked Questions
Why is it called a "cafeteria" plan?
Because employees choose from a menu of pre-tax benefit options.
Does a Section 125 plan reduce payroll taxes for the employer too?
Yes—it reduces the wage base subject to the employer’s FICA match.
Can elections change mid-year?
Generally only during open enrollment or after a qualifying life event.
Can an employer offer a Section 125 plan without an FSA?
Yes—a premium-only plan (POP) is a simple form of Section 125 plan that lets employees pay their share of health premiums pre-tax without adding FSA or dependent care options.
What happens to unused Section 125 elections at year-end?
It depends on the underlying benefit—premium elections simply end, while FSA funds are typically subject to use-it-or-lose-it rules unless the plan allows a grace period or small carryover.
Related terms: FSA vs. HSA vs. HRA, Health Insurance Open Enrollment, Dependent Care FSA