Cafeteria plans are flexible spending plans employers provide as a way for employees to reduce their taxable income by contributing pretax dollars to benefit accounts for qualified expenses, such as medical or dependent-care expenses.
Cafeteria plans are great ways to reduce taxable income while providing essential benefits to employees. Learn more about what they are and how they work.
Definition and Examples of a Cafeteria Plan
A cafeteria plan is an employer-sponsored program through which employees can elect to contribute pre-tax dollars to benefit accounts for certain qualified expenses—approved medical, dependent care, and adoption expenses, and insurance premiums not covered by your insurance, for example. Employees are reimbursed throughout the year from these accounts as the expenses are incurred.
- Alternate names: Section 125 plan, flexible benefits plan
A health care flexible spending account (FSA) is an example of a benefit offered under a cafeteria plan. A flexible spending arrangement is an employer-sponsored benefit that allows you to contribute pretax dollars to use for out-of-pocket medical expenses not covered by your health plan.
How a Cafeteria Plan Works
At its core, a cafeteria plan is designed to give employees benefits choices—much in the same way you’d have food choices in a cafeteria—and generate tax savings. During your company’s open enrollment period, you decide if you want to enroll in a cafeteria plan, choose how much you’d like to contribute to your plan (“election”), and choose the qualified benefits you want to receive. Keep in mind that you can’t change your election unless you have a qualifying circumstance (qualifying change in status) such as a marriage, divorce, or birth of a child.
Qualified benefits eligible for cafeteria plans include:
- Health insurance premiums (excluding Archer medical savings accounts or long-term care insurance)
- Accident insurance
- Adoption expenses
- Dependent-care expenses
- Group term life insurance coverage
- Health savings accounts, including long-term care services
- Flexible spending accounts (FSA)
When an expense not covered by your health insurance comes up, you can use your cafeteria plan funds to pay for your expenses. Keep in mind, though, that you lose any unused money you contribute to your plan.
Your employer should provide you with documents that detail the benefits, rules, and eligibility available through the plan.
Let’s use an FSA as an example. During open enrollment, you specify that you want to put $2,850 (the maximum amount allowed) in your FSA for the year. That amount will be divided by the number of pay periods, and a corresponding number will be withheld from the paycheck every pay period—$200 if you’re paid every two weeks.
In the new plan year, the full amount you elected to withhold for the year is deposited into your account by the employer; the employer essentially fronts the account money for the next year.
The money in this account is to be used only for qualified medical purchases and must only be used within the plan year.
When you incur a qualified expense, you’ll submit proof of payment to the FSA account’s administrators. Reimbursement will come in the form of a check or direct deposit, depending on how your account was set up.
Unless your company’s documentation says otherwise, you will forfeit any unused funds left in your cafeteria plan at the end of the year.
How Cafeteria Plans Offer a Tax Break
As for tax savings, cafeteria plans tend to reduce your tax liability because your medical expenses are taken out pretax:
|Cafeteria Plan||Non-Cafeteria Plan|
|Pretax benefits payment for health insurance||$200||$0|
|Taxes paid at 20% tax rate||$360||$400|
|Post-tax benefits payment for health insurance||$0||$200|
“I think that employees often overlook the fact that making an election to contribute to a cafeteria plan will result in a lower tax burden for them,” William Sweetnam, a legislative and technical director for Employers Council on Flexible Compensation (ECFC), told The Balance by email. “However, since they have to make the salary reduction election at the beginning of the year, an employee may be unaware of the tax benefits that he will have all through the year.”
Do You Need a Cafeteria Plan?
The main benefit of a cafeteria plan is its power to lessen your tax burden by providing benefit accounts for health and dependent-care expenses. Many individuals would benefit by planning to use these accounts for medical and dependent-care expenses.
Determining how much money you want to set aside for the year can be a challenge—one you’ll want to discuss with your benefits administrator or tax professional. If you don’t use all your money in the plan, you’ll lose it, so a cafeteria may be a good choice for fixed-cost qualified benefits such as health insurance premiums.
How To Get a Cafeteria Plan
Cafeteria plans are available to employees, their spouses, and dependents. You’re eligible to enroll when hired or during your employer’s open enrollment period for the plan year.
To find specifics about the program you’re interested in, you can visit your employer’s benefit website or ask your HR representative for it.
Self-employed individuals are generally not eligible to set up cafeteria plans.
Employers interested in setting up a cafeteria plan for their employees can begin by adopting a written plan document, making sure employees know their plan elections are irrevocable for the plan year, and satisfying nondiscrimination requirements for the benefits provided.
- Cafeteria plans sponsored through an employer can reduce your taxable income.
- You can use your cafeteria plan to pay for qualified medical expenses, contribute to an FSA, or pay health insurance premiums.
- Qualified benefits include adoption expenses, accident and health benefits, dependent-care costs, group term life insurance, and health savings accounts.
TASC. "Section 125 Cafeteria Plan."
IRS. "Publication 15-B: Employer's Tax Guide to Fringe Benefits," Page 2.