Cafeteria plan
What is a cafeteria plan in HR?
A cafeteria plan, also known as a Section 125 plan, is a type of employee benefits program where employees choose from a range of pre-tax benefits that suit their needs. It allows them to convert taxable benefits (such as salary and cash allowances) into non-taxable benefits, which are deducted from gross income before taxes are applied.
The main goals of offering a cafeteria plan are to reduce tax liabilities, boost employee satisfaction, and promote flexibility in benefits management. By providing the choice to customize their benefits, organizations can increase retention and support employees who have expenses related to medical care, insurance, and other related needs.
How does a cafeteria plan work?
This plan acts like a "menu," where employees choose benefits that fit their needs—such as health, dental, or vision insurance—through pre-tax payroll deductions. Because the selected benefits are paid before taxes, this program lowers their taxable income and increases their take-home pay.
Employers also benefit from reduced payroll taxes, making the plan financially advantageous for both sides. Employees can typically modify their benefit selections during annual enrollment periods or after major life changes, ensuring their choices stay relevant.
What are the advantages of a cafeteria plan?
Tax liability
Employees pay for selected benefits with pre-tax income, lowering their taxable earnings. Employers also save on payroll taxes, creating a financial win for both sides.
Flexibility
Employees can tailor their benefits to match personal and family needs instead of being stuck with a generic package that doesn’t fit their lifestyle.
Higher employee satisfaction and retention
When employees get to choose what works best for them, they feel more valued and supported. This boosts engagement and encourages them to stay longer with the organization.
Cost efficiency for employers
Since a portion of compensation shifts into pre-tax benefits, employers can reduce overall payroll expenses while still offering attractive perks, making benefits management more budget-friendly.
What are the disadvantages of a cafeteria plan?
Complex administration
Managing a cafeteria plan can be time-consuming, as it requires compliance with tax laws, accurate documentation, and ongoing benefit tracking. This often increases HR workload and may require specialized systems or external support.
Risk of poor choices
Employees might select benefits that seem cheaper upfront but don’t actually meet their long-term needs, which could lead to financial strain or limited coverage later.
Eligibility restrictions
Not every worker can participate in a cafeteria plan. Contractors, part-timers, interns, and certain business owners or shareholders may be excluded due to IRS rules, leading to possible fairness concerns.
Potential cash flow
Employers may need to pay benefit providers before they fully recoup costs through payroll deductions, creating short-term cash flow challenges for the organization.
Who is and isn't eligible for a cafeteria plan?
Generally, most regular full-time and part-time employees are eligible to enroll in a cafeteria plan, as long as they receive a W-2 form for tax purposes. New hires typically become eligible after completing the organization’s waiting period or enrollment window. The plan can also extend coverage to an employee’s spouse and dependents if the selected benefits allow it. Independent contractors and other self-employed individuals are not eligible for this type of program.
What types of benefits can be included in a cafeteria plan?
Cafeteria plans include a variety of pre-tax benefit options that employees can pick and choose from based on their needs:
- Health insurance
- Dental and vision insurance
- Flexible spending accounts (FSAs)
- Health savings accounts (HSAs)
- Dependent care assistance
- Group life insurance (within IRS limits)
- Disability insurance
- Adoption assistance programs