Cafeteria plan
Summary definition: An employer-sponsored benefits plan that lets employees choose between one or more qualified pre-tax benefits under Internal Revenue Code Section 125.
What is a Section 125 cafeteria plan?
A cafeteria plan is a benefits program that allows employees to pay for certain qualified benefits using pre-tax payroll deductions. By reducing taxable income, this arrangement increases the overall value of the plan and its benefits, since employees owe less in income taxes and retain more of their earnings.
The term “cafeteria” refers to plans giving employees a menu of benefit options to choose from, including health coverage, dependent care assistance, and certain spending accounts, while reducing their taxable wages.
Key takeaways
- A cafeteria plan is an employee benefit plan under Section 125 of the Internal Revenue Code that allows workers to enroll in health plans that best suit their needs.
- Cafeteria plans include various requirements and benefit options, such as savings and spending accounts (e.g., FSAs, HSAs, and DCAPs).
- Employers offering Section 125 cafeteria plans must comply with documentation guidelines, nondiscrimination testing, and administrative regulations to ensure equitable access and tax advantages for all eligible employees.
What is Section 125?
Because a cafeteria health plan must comply with the requirements of Internal Revenue Code (IRC) Section 125, the arrangements are also commonly called a Section 125 cafeteria plan, Section 125 plan, cafe 125 plan, sec 125 plan, or 125 cafeteria plan. Under these rules, participants must be permitted to choose between taxable compensation and qualified non-taxable benefits.
Moreover, compliant cafeteria plans must be maintained under a written plan document. That document should describe the arrangement’s eligibility, election rules, available benefits, and procedures for making or changing elections.
How do cafeteria plans work?
A cafeteria plan generally works through pre-tax payroll deductions. During open enrollment (or a qualifying special enrollment period (SEP)), employees elect the benefits they want and authorize the corresponding Section 125 deductions from their wages.
Those elections usually stay in place for the plan year unless the employee experiences a permitted qualifying event.
Cafeteria plan types
Section 125 plans come in a variety of forms based on the benefits they offer beyond medical, dental, or vision insurance.
| Plan type | Details |
|---|---|
| Full flex cafeteria plan | Employees use contributions to select benefits that meet their needs and build up savings accounts or spending arrangements that pay for any qualified medical expenses not fully covered by employer funds. |
| Simple cafeteria plan | A condensed version of standard cafeteria plan insurance for small employers (i.e., up to 100 employees). Standard nondiscrimination tests are bypassed as the workforce’s small size makes uniform employer contributions easier. |
| Premium only plan (POP) | A limited cafeteria insurance plan type in which pre-tax deductions may only go toward plan premiums (i.e., no savings or spending accounts are allowed). |
Other cafeteria plan benefits
Based on the type of cafeteria plan an employer offers, employees may have access to additional savings or spending arrangement benefits, including:
- Health Savings Account (HSA): Employees contribute additional pre-tax wages into a tax-advantaged account for covering eligible medical expenses.
- Flexible Spending Account (FSA): Similar to an HSA, but any unused funds still in the account after the end of the plan year are lost.
- Dependent Care Assistance Plan (DCAP): A special version of an FSA employees can use to cover the costs of caring for children under 13 or elderly parents.
Section 125 cafeteria plan compliance
Aside from the basic cafeteria plan requirements outlined in Internal Revenue Code 125, plan administration can quickly become complex for employers.
Many, therefore, partner with a service provider offering benefits administration tools that integrate with HR and payroll systems to support enrollment, deduction accuracy, documentation, and compliance.
IRC Section 125 nondiscrimination testing
To ensure cafeteria plans don’t favor certain workers or highly compensated employees (HCEs) at the expense of others, IRS Section 125 rules require such plans to undergo annual nondiscrimination testing. The three test types include:
| Test | Purpose | Criteria |
|---|---|---|
| Eligibility test | Ensures the plan is offered broadly and fairly to all eligible employees | Plans must use consistent eligibility criteria for all employees (with limited exceptions), and any waiting period to enroll in the plan must be three years or less. |
| Contributions and benefits test | Verifies contributions and benefits aren’t skewed toward HCEs* | HCE contributions and benefit allocations must be proportionally equal to or less favorable than those for non-HCEs. |
| Key employee concentration test | Assesses if key employees receive a disproportionate share of pre-tax benefits** | No more than 25% of the total pre-tax benefits can be allocated to key employees, as defined by factors such as ownership stakes or specified compensation levels. |
*Includes officers, individuals who own more than 5% of company stock, and employees earning above an annually updated compensation threshold.
**Includes officers earning above a different annually updated compensation threshold who own at least 5% of the company.
Section 125 cafeteria documentation
Most cafeteria plans are also covered by the Employee Retirement Income Security Act (ERISA), and therefore must meet the same documentation, reporting, and administrative requirements as retirement plans (e.g., 401(k) or 403(b) plans).
As such, employers should maintain several plan-related documents, including:
- Main plan document: The primary document outlining all of the plan’s offerings, benefits, and legal obligations for the employer.
- Adoption agreement: Formal documentation showing that the employer adopted the Section 125 benefit plan outlined in the main plan document (often included as part of the main plan document).
- Summary plan description (SPD): An abridged version of the main plan document intended for employee use. All eligible employees should receive one within 90 days of enrolling in the plan, and it should be refreshed approximately every five years.
Filing requirements for an IRS Section 125 plan can vary depending on whether it offers any welfare benefits. If so, the employer may need to file Form 5500 with the U.S. Department of Labor annually.
Optimize Your Benefits Experience
Help your employees get the most out of their benefits while getting time back in your day through smart automation. With all-in-one tools, kicking off open enrollment and administering third-party benefits services like FSAs, HSAs, and more is a breeze! And employee experience features like integrated training and expert groups, all available on the go, ensure your employees are making informed decisions.