What is a 'Cafeteria Plan'

A cafeteria plan is an employee benefit plan that allows staff to choose from a variety of pretax benefits. A Cafeteria plan also refers to as a "flexible benefit plan" or Section 125 plan.

BREAKING DOWN 'Cafeteria Plan'

A cafeteria plan gets its name from a cafeteria, where individuals select their food of choice, employees may choose benefits of their choice before taxes are calculated. These plans become more useful as diversity within workforces continues to grow and employees seek personalized benefits.

Section 125 of the Internal Revenue Code specifies that cafeteria plans are exempt from the calculation of gross income for federal income tax purposes. No federal, state or Social Security taxes are deducted, allowing employees to potentially save between 25- and 40% of every dollar they contribute to the plan.

Cafeteria Plan Selections

Cafeteria plan selections include insurance options, such as contributions to health savings accounts, or group term life insurance and disability insurance. Other popular selections include retirement plan contributions, adoption assistance plans, flexible spending accounts and cash benefits. Flexible plan selections allow employees to tailor a cafeteria plan to their specific needs. For example, the best selection for an employee reaching retirement might be to make contributions to his or her 401(k) plan, while an employee with a large family may be better suited to a health plan that has broad coverage.

Cafeteria Plan Contributions

Employees must estimate how much money they are going to contribute to their cafeteria plan before the tax year begins. The elected amount of money is divided by the number of payroll periods and deducted from each paycheck for the duration of the plan; allocated money not spent by the employee is forfeited. For instance, if John allocates $2,000 for medical expenses but only spends $1,500, he forfeits $500. Employees that exceed their allocated spending amount, pay a partial premium to their employer. For example, if an Emma spends $1,000 over her allocated contribution, she pays a portion of that amount herself.

Cafeteria Plan Limitations

The individualized setup of cafeteria plans makes them more complex and time-consuming to administer. Employers must maintain constant communication with each employee about changes in the cost of benefits, their coverage and their use of benefits. Employees changing circumstances may result in continual administration. This can partly be rectified by only allowing staff to change their benefits periodically. For example, a company might only allow employees to change their cafeteria plan benefits once a year. If an employee uses the full benefit of their plan and leaves the company before they have paid their yearly contribution, the employer incurs a loss.

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