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Every employee in your organization has different benefits requirements, especially when it comes to their medical needs. One worker may need coverage to support their diabetic child, while another seeks treatment for persistent back pain. And there will be some lucky enough not to require any medical support at this point in their lives.
It’s clear that one-size-fits-all benefits don’t fit anyone perfectly. Instead? Cafeteria plans provide exactly what your workers need—choice. This guide explains more about how cafeteria plans work, their pros and cons, and compliance requirements.
A cafeteria plan is an employer-sponsored benefits program that lets employees choose a personalized mix of taxable and nontaxable benefits for themselves and their dependents. Also known as a Section 125 plan, it’s named for its flexibility. Think of it like choosing a selection of dishes from a buffet—employees can pick the benefits that delight them and best suit their needs.
Cafeteria plans aren’t new. They were formally established under Section 125 of the Internal Revenue Code in 1978. Before that, offering employees a choice between cash and benefits often triggered tax consequences. The Revenue Act of 1978 changed that, allowing employers to offer customizable, tax-advantaged benefit menus, marking the beginning of what is now known as flexible benefits or cafeteria-style plans.
The IRS defines a list of qualified, non-taxable benefits you can offer through a cafeteria plan. Employers can mix and match from this list to build a plan that supports employee needs while minimizing tax liability for both sides. Here are the most common qualified benefits:
Even in the world of benefits pick-and-mix, not everything qualifies for pre-tax treatment. Some popular perks don’t make the cut under Section 125 rules, including:
Employers can still offer these employee lifestyle benefits, but they need to handle them outside the cafeteria plan framework.
At its core, a Section 125 cafeteria plan is designed to be simple to run and access. Here are the nuts and bolts of how it works.
The employer designs the cafeteria plan by choosing a mix of benefits to offer. To qualify under Section 125, the employee benefits plan must include:
Each year, key employees choose their benefits during the open enrollment period, which is in the fall before the upcoming plan year. These elections are generally locked in for the entire year.
But employees can make changes outside of open enrollment if they experience a qualifying life event (QLE). These are specific personal or family changes that affect benefit eligibility and allow mid-year adjustments under IRS rules.
Examples of QLEs include:
Example: If an employee gets married in April, they may be able to add their new spouse to their health plan and adjust their FSA contributions, even though open enrollment has passed. They must act quickly: Most QLEs must be reported and addressed within 30 days of the event.
Once employees select their benefits, the cost is automatically deducted from their paycheck before income tax withholding is applied. These are called pre-tax payroll deductions. Essentially, they reduce the employee’s taxable gross income for federal income tax purposes.
This setup lowers both the employee’s income tax and payroll taxes (like Social Security and Medicare), while also reducing the employer’s payroll tax liability.
Example: Let’s say an employee earns $60,000 per year and elects to contribute $3,000 to a health FSA and $2,500 toward their share of health insurance premiums. That’s $5,500 in pre-tax deductions, meaning they’ll only be taxed on $54,500 of income, not the full $60,000.
At a combined tax rate of 30%, that’s a potential tax savings of around $1,650 for the employee. Meanwhile, the employer also saves on payroll taxes for high fives all around.
Employees can contribute pre-tax dollars to an FSA while also using other cafeteria plan benefits like health insurance or dependent care assistance. To stay compliant, you’ll need to set a clear employer contribution limit for any FSA included in the cafeteria plan. Without that cap, the FSA isn’t considered part of the Section 125 plan and loses its tax benefits.
Employers can structure Section 125 plans in several different ways depending on headcount, benefits strategy, and administrative capacity. While each plan type differs primarily in scope and complexity, all must meet the requirements of Section 125 to maintain their tax-advantaged status. Below are the most common types of cafeteria plans employers offer:
Note: Archer medical savings accounts (MSAs) are technically allowed under Section 125, but they’re limited to certain small employers and self-employed individuals and are largely phased out in favor of HSAs.
Along with conforming to Section 125 of the Internal Revenue Code, cafeteria plans must also adhere to the Employee Retirement Income Security Act—the federal law that governs most employer-sponsored benefit plans. Don’t worry, it’s easier than it sounds:
If your cafeteria plan offers ERISA-covered benefits like group health insurance, disability insurance, or adoption assistance, then you’ll need to follow certain documentation and reporting requirements, just like you would for a 401(k) or 403(b) retirement plan.
Here’s what that usually involves:
Note: ERISA doesn’t apply to all cafeteria plans; for example, those offering only non-ERISA benefits like HSAs or dependent care FSAs may be exempt from some requirements. But if you offer group insurance, ERISA likely applies.
Like any type of employee benefit, cafeteria plans come with their own unique blend of advantages and disadvantages, whether considering them through an employer or employee lens.
Here’s why so many organizations use cafeteria plans as a core part of their total rewards strategy:
Cafeteria plans enable employees to pay for benefits with pre-tax income, which reduces their taxable wages. The result is more take-home pay without increasing gross salary.
Meanwhile, employers also benefit from reduced payroll tax obligations, including Social Security and Medicare taxes. CEO Kuya William Peetoom describes the win-win:
“Imagine being able to increase your employees’ take-home pay without raising wages… while simultaneously lowering your own business taxes and insurance costs.”
Employees can tailor their benefits to suit their individual circumstances, whether maximizing dependent care, enrolling in a health FSA, or skipping optional coverage altogether.
Cafeteria plans meet a wide range of needs, from young employees saving on premiums to working parents needing dependent care support.
Common options like health insurance, disability coverage, adoption assistance, and HSA contributions are all non-taxable under Section 125 when included in a compliant plan.
Offering flexible, tax-efficient benefits is a strong differentiator in competitive hiring markets, especially for cost-conscious or family-focused employees.
There’s a bit of red tape involved with using cafeteria plans. But once set up, companies usually find that the long-term tax savings and employee satisfaction often outweigh the upfront complexity.
Some benefits, like health and dependent care FSAs, follow strict “use it or lose it” guidelines. If employees don’t spend their allocated funds by the end of the plan year (or grace period, if offered), the remaining balance is forfeited.
Outside of open enrollment, employees can only adjust their benefit selections if they experience a QLE. This can make cafeteria plans feel rigid for employees whose needs change mid-year.
Especially for small or lean HR teams, managing cafeteria plans can require time and expertise, from setting up pre-tax deductions to ensuring proper documentation and ERISA compliance. Business advisor Jason Charles describes:
“Some companies hesitate to implement Cafeteria 125 Plans due to perceived complexity or administrative burden. However, with the right guidance and tools, setting up and managing these plans can be straightforward and highly beneficial.”
One of the biggest considerations of offering a cafeteria plan is also what makes it so powerful: customization. Because employees can build their own mix of benefits, no two elections may look the same. And that flexibility creates complexity on the backend for employers.
To stay compliant with Section 125 of the Internal Revenue Code, employers must maintain specific documents and follow key reporting rules for certain benefits.
Every Section 125 cafeteria plan must have a written plan document in place, as a legal requirement. The core documents include:
To qualify as a cafeteria plan, employees must be able to choose between at least one taxable benefit (like cash) and one qualified, non-taxable benefit (like health insurance or an FSA). If you don’t offer a taxable benefit, this doesn’t meet IRS standards for a Section 125 plan.
Keep in mind:
Cafeteria plan filing requirements depend on whether the plan includes ERISA-covered welfare benefits, such as group health, dental, vision, disability, or adoption assistance.
Offering cafeteria plans for your employees is made easy when you have the right support to guide you. Benepass is a versatile benefits administration platform designed to offer your employees choice, while making it easy to run on the backend. Here’s what you can expect:
Ready to give your employees the choice they want, need, and expect from their benefits program? Book a free Benepass demo today to see our platform in action, or contact sales@getbenepass.com to discuss your cafeteria plan queries with a benefits specialist.
