What is a Cafeteria Plan?
A Cafeteria Plan, also known as a section 125 Plan, is a written plan that allows employees to receive part of their compensation as an employee benefit, paid for with pretax dollars.
Cafeteria Plans have two tax advantages:
- Employee contributions toward cafeteria-plans benefits are made pre-tax.
- Employer contributions toward an employee’s cafeteria-plan benefits are not taxed and not counted as employee income.
The tax savings for employees through the use of pretax dollars to pay for benefits can be substantial. For example, an employee who spends $200 a month in pretax dollars for benefits can, in effect, save $60, assuming about 30 percent of the $200 would have gone to federal, state and local incomes taxes and FICA (the taxes deducted for Social Security and Medicare).
Premium-only plans (POPs), allow employees to choose between receiving their full salary in cash or using a share of that salary to pay group insurance policy premiums on a pretax basis.
Full Flex Plans
With Full Flex Plans, employers make contributions for all plan-eligible employees, and employees use those contributions to buy various benefits. Employees can then make pre-tax contributions towards any benefit that the employer contributions do not fully cover.
Flexible Spending Arrangements
Flexible Spending Arrangements (FSAs) allow employees to make contributions toward health care and dependent care expenses on a pretax basis.
Cafeteria plans are generally subject to the nondiscrimination requirements of the IRS section 125. To satisfy the section 125 nondiscrimination requirements, a plan generally must fulfill the following three tests:
- Eligibility Test: The plan may not discriminate in favor of highly compensated individuals as to eligibility to participate.
- Benefits and Contributions Tests: The plan may not discriminate in favor of highly compensated participants as to benefits and contributions.
- Key Employee Concentration Test: The nontaxable benefits provided to key employees may not exceed 25 percent of the nontaxable benefits provided for all employees under the cafeteria plan.
If a plan fails any of these nondiscrimination tests, the highly compensated participant or key employee participating in the plan will lose the favorable tax treatment of the cafeteria-plan benefit and must include in his or her gross income the value of the taxable benefit with the greatest value that the employee could have elected to receive. Participants who are not highly compensated or key employees will not lose their tax benefits and are not impacted by the failure of a plan to pass nondiscrimination testing.