A cafeteria plan is just a fancy term for a certain way to group the employee benefits you get at work, like health insurance. It's important because if you're paying for any of the benefits, a cafeteria plan is a way to pay for them with pre-tax income, which is not federally taxed.
Cafeteria plans are sometimes called Section 125 plans, after its section in the tax code. Participants must be able to choose between at least one taxable benefit (such as cash) and one qualified benefit – like health insurance. A Section 125 plan is the only way an employer can offer workers a choice between taxable and nontaxable benefits without the choice causing the benefits to become taxable. If a plan offers only choices among taxable options, it’s not a Section 125 plan.
How Does a Cafeteria Plan Work?
The plan usually starts with an agreement between you and your employer for you to use pre-tax income to pay for the benefits. You never receive that money, so it's not federally taxed – no federal income tax, and no Social Security or Medicare tax.
The benefits purchased with your contributions are called qualified benefits, and they include:
- Accident and health benefits (but not Archer medical savings accounts or long-term care insurance)
- Adoption assistance
- Dependent care assistance
- Group term-life insurance coverage
- Health savings accounts, including distributions to pay long-term care services
One type of health savings account available to cafeteria plan participants is the Flexible Spending Arrangement (FSA). When you sign up for one, you get what is essentially a savings account funded by your pre-tax dollars, and reimburses you for qualifying healthcare expenses. There's an annual maximum benefit and funds are not “rolled over” at the end of the year. No rollover means “use it or lose it”: use your contributions by the end of the year, or you won't get them back.
An FSA may be offered for dependent care assistance, adoption assistance and healthcare reimbursements.