Cafeteria Plan

A cafeteria plan is a written plan under which all participants are employees and the participants may choose among two or more benefits consisting of cash and qualified benefits. That is the statutory definition, at Internal Revenue Code section 125(d)(1), and every word of it is doing work: the plan must be written, it must be for employees, and it must offer a real choice that includes cash.

The plan's purpose is narrow and almost invisible to the people who use it. Section 125(a) provides that no amount is included in a participant's gross income "solely because, under the plan, the participant may choose among the benefits of the plan." Without that sentence, the ordinary doctrine of constructive receipt would tax an employee on cash they could have taken even if they took the health coverage instead. Section 125 is what makes the employee's choice tax-free, which is why almost every pre-tax payroll deduction — health premiums, a health flexible spending account, a dependent care FSA, payroll contributions to a health savings account — is running through one whether or not the employer ever uses the phrase.

Because Code section 125 is literally titled "Cafeteria plans", the common name and the official name are the same here. "Section 125 plan" and "flexible benefit plan" are the same arrangement described by its Code section and by its design.

The section defines what may be inside the plan, and the exclusions are more surprising than the inclusions. A "qualified benefit" under section 125(f)(1) is any benefit that, with the application of section 125(a), is not includible in the employee's gross income "by reason of an express provision of this chapter (other than section 106(b), 117, 127, or 132)." Read the parenthetical carefully, because it removes four whole categories:

• Section 127 educational assistance cannot be a cafeteria plan benefit, even though it is tax-free.
• Section 132 fringe benefits cannot either, which is why commuter benefits run on their own separate statutory authority rather than through a cafeteria plan.
• Section 117 qualified scholarships and section 106(b) Archer MSA contributions are out for the same reason.

Two further exclusions sit just below. Section 125(f)(2) says a qualified benefit "shall not include any product which is advertised, marketed, or offered as long-term care insurance." Section 125(f)(3) generally excludes a qualified health plan bought through an Affordable Care Act Exchange, with a narrow exception where the employer is itself offering Exchange coverage in the group market.

Deferred compensation is excluded, with four carve-outs. Section 125(d)(2)(A) states flatly that a cafeteria plan "does not include any plan which provides for deferred compensation," and that single sentence is why unspent FSA money cannot simply roll into next year. The carve-outs are narrow: subparagraph (B) permits a qualified cash or deferred arrangement, so a 401(k) election can sit inside the plan; subparagraph (C) covers certain post-retirement group life contributions at educational institutions; and subparagraph (D) permits health savings account contributions.

The payroll-tax point is the one people size wrong. Section 3121(a)(5)(G) excludes from Social Security and Medicare wages a payment made under a cafeteria plan, provided the payment would not have been wages without regard to the plan. So a pre-tax health premium escapes income tax and payroll tax alike. The elective deferral to a traditional 401(k) is the exception that proves the rule: it would be wages anyway, so it escapes income tax only and Social Security and Medicare tax are still charged on it.

The plan can lose the exclusion for the people it favors. Section 125(b) contains two separate tests, and they apply to two different groups. For a highly compensated participant — an officer, a more-than-5-percent shareholder, someone who is highly compensated, or a spouse or dependent of any of those — section 125(a) does not apply to any benefit attributable to a plan year in which the plan discriminates in favor of highly compensated individuals as to eligibility, or highly compensated participants as to contributions and benefits. For a key employee within the meaning of section 416(i)(1), section 125(a) does not apply if the qualified benefits provided to key employees exceed 25 percent of the aggregate qualified benefits provided to all employees under the plan. In either case the benefit is treated as received in the participant's taxable year in which the plan year ends. The consequence falls on the employee, not the employer, which is the part that surprises people.

A small employer can buy its way out of the testing. Section 125(j) creates the "simple cafeteria plan": an employer that averaged 100 or fewer employees in either of the two preceding years, and that makes a minimum employer contribution for every qualified employee, is treated as meeting the nondiscrimination requirements automatically. The contribution has to be either a uniform percentage of at least 2 percent of compensation, or the lesser of 6 percent of compensation and twice the employee's own salary reduction, and it has to be made whether or not the employee contributes anything. In exchange, the plan stops having to pass the section 125(b) tests, along with several others.

Elections are locked, and the lock has a specific legal shape. Treasury Regulation section 1.125-4(a) provides that a cafeteria plan "may permit an employee to revoke an election during a period of coverage and to make a new election only as provided in paragraphs (b) through (g) of this section," and then adds the sentence most readers need: "Section 125 does not require a cafeteria plan to permit any of these changes." The events themselves, and the difference between a change in your circumstances and a change in the plan's cost or coverage, belong to the qualifying life event entry.

1. The employer adopts a written plan document naming the benefits employees may choose among, one of which has to be cash.

2. The employee elects, normally before the plan year begins, how much salary to redirect to each benefit.

3. Payroll applies the elections before computing tax. The redirected amount is not paid as wages, so it does not appear in the wage boxes that income tax and, for most benefits, Social Security and Medicare tax are computed on.

4. The election holds for the plan year, unless the plan document permits a change and one of the regulation's events has occurred.

5. After the year ends, the plan is tested. If it discriminated in favor of highly compensated participants, or if key employees took more than 25 percent of the qualified benefits, the exclusion is lost for those individuals and the value lands in their income.

A hypothetical illustration of the nondiscrimination consequence. A cafeteria plan covers 40 employees. Rafael is an officer, so he is a highly compensated participant under section 125(e)(1)(A). During the plan year he elects $4,800 of pre-tax health premiums and $2,000 to a health flexible spending account, $6,800 in all. After the year ends the plan's administrator finds that the plan discriminated in favor of highly compensated individuals as to eligibility.

The result is not a penalty on the employer. Section 125(a) simply stops applying to Rafael, so the full $6,800 becomes taxable income to him, reported in the taxable year in which the plan year ends. His colleagues who are not highly compensated participants keep their exclusion in full: the test names who loses it, and it is not everybody. All figures are illustrative.

Pros

• It is the only mechanism that lets an employee choose between cash and a benefit without being taxed on the cash they declined.
• The exclusion reaches Social Security and Medicare tax as well as income tax for most benefits offered through the plan, which makes the saving larger than a traditional retirement deferral of the same size.
• It requires no action from the employee beyond electing, and the saving arrives automatically in every paycheck rather than at filing.
• A small employer can adopt the simple cafeteria plan under section 125(j) and skip the nondiscrimination testing entirely.

Cons

• The election is locked for the plan year unless the plan document itself permits a change, and the plan is free to permit none of them.
• Four significant categories of tax-free benefit — educational assistance, section 132 transportation fringes, qualified scholarships and Archer MSA contributions — cannot be offered through the plan at all.
• A plan that fails the section 125(b) tests takes the exclusion away from the highly compensated participants and key employees, after the fact, in a year they can no longer change their elections.
• Reducing taxable wages also reduces the earnings on which Social Security benefits are calculated, which is a small cost that only shows up decades later.
• Employees rarely see the plan document, so the terms that actually control their choices are documents they have to ask for.