Section 125 plan
Also known as: cafeteria plan, flexible benefit plan
A Section 125 plan is an employer-sponsored benefit arrangement that lets employees choose between taxable cash and qualified pre-tax benefits such as health insurance. Contributions made through the plan reduce the employee's taxable income.
A Section 125 plan — commonly called a cafeteria plan — takes its name from Section 125 of the Internal Revenue Code. Its defining feature is choice: the plan must offer employees at least one taxable option (cash or salary) and at least one qualified non-taxable benefit. Employees select the mix they want, which is where the cafeteria analogy comes from.
The tax advantage is the point. Amounts an employee elects to put toward qualified benefits are taken from pay before federal income tax and, in most cases, before Social Security and Medicare taxes, so both the employee's and the employer's payroll tax burden falls. Qualified benefits typically include accident and health coverage, group term life insurance (coverage above the statutory limit may still be offered, but the excess creates imputed taxable income), dependent care assistance, adoption assistance, health savings account contributions, and health and dependent care flexible spending accounts.
Rules constrain how the plan works. Elections are generally locked in for the plan year and can be changed only after a qualifying life event such as marriage, divorce, birth or adoption, or a change in employment status. Health FSA balances are subject to a use-it-or-lose-it rule, softened by whichever option the employer adopts — a limited carryover or a short grace period. Certain benefits are specifically excluded from cafeteria plans, and nondiscrimination testing prevents the plan from disproportionately favoring highly compensated or key employees.
Health and life and health insurance licensing exams cover Section 125 plans in the group benefits material. Be able to identify the plan as a cafeteria arrangement offering a choice between cash and qualified benefits, name which benefits qualify, and recognize the pre-tax treatment, the qualifying-event rule for mid-year election changes, and the nondiscrimination requirement.
Key takeaways
- A Section 125 plan, or cafeteria plan, lets employees choose between taxable cash and qualified pre-tax benefits.
- Elected amounts are deducted before income and payroll taxes, lowering taxable income for the employee and payroll tax for the employer.
- Qualified benefits include health coverage, group term life within limits, dependent care assistance, HSAs, and FSAs.
- Elections are fixed for the plan year unless a qualifying life event occurs.
- Nondiscrimination testing prevents the plan from favoring highly compensated or key employees.