What it means
Traditional benefits packages are the same for everyone, which suits nobody perfectly. A young employee may want more take-home pay and a health plan, a parent may value dependent care assistance, and an older employee may prioritise wider medical cover.
A cafeteria plan gives each of them a budget and a choice. The tax advantage is what makes the structure worth the administration.
Salary directed into qualifying benefits is excluded from taxable wages, so the employee avoids income tax and payroll tax on that amount, and the employer avoids its share of payroll tax too. In the United States these arrangements sit under Section 125 of the tax code, which is why they are often simply called Section 125 plans.
The menu is not unlimited. Qualifying items typically include health insurance premiums, health savings account contributions, flexible spending accounts for medical or dependent care, group term life cover within limits and certain disability policies.
Items such as most educational assistance and long-term care generally cannot be offered through this route. The most important restriction is that elections are irrevocable for the plan year.
Once an employee decides to direct $2,400 into a dependent care account, they usually cannot change that until the next enrolment window unless a qualifying life event occurs, such as marriage, a birth or a change in a spouse's employment. Under-electing wastes tax relief and over-electing risks forfeiting unused funds.
Plans must also pass non-discrimination tests designed to stop the benefit being concentrated among owners and highly paid staff. If the tests fail, the favoured employees lose the tax exclusion and are taxed on the amounts they elected, which is an unpleasant surprise arriving after the year has closed.
This is why smaller companies usually run the plan through a third-party administrator.
In practice
Real-world examples
Example 1
A manufacturer with 300 employees runs a cafeteria plan in which the average election is $5,000, giving $1,500,000 of pre-tax elections in total. The employer's payroll tax saving is $1,500,000 x 0.0765 = $114,750, which more than covers the plan's administration fee.
Example 2
An employee elects $3,200 into a medical flexible spending account, then has a quieter year for medical costs than expected. She spends $2,950 and forfeits the remaining $250 under the plan's use-it-or-lose-it rule.
Example 3
A marketing agency adds dependent care assistance of up to $5,000 per year to its menu. An employee in the 24% federal bracket who elects the full amount saves $5,000 x 0.24 = $1,200 in federal income tax alone, before payroll tax savings.
Think of it
Think of a cafeteria plan like a set-lunch menu versus a buffet. Instead of forcing everyone to eat the standard roast dinner, you are given tokens to pick your own plate from a selection of healthy options, paying less because you only take what you actually need.
Formula
Calculation
Taxable pay = gross salary - qualifying pre-tax elections. Employee tax saved = total elections x combined marginal tax and payroll tax rate. Employer payroll tax saved = total elections x employer payroll tax rate.
An employee earns $80,000 and elects $6,000 for health insurance premiums and $2,400 for dependent care, a total of $6,000 + $2,400 = $8,400. Taxable pay falls to $80,000 - $8,400 = $71,600.
If the employee faces a 22% marginal income tax rate plus 7.65% in payroll tax, the combined rate is 22% + 7.65% = 29.65%. The tax saved is $8,400 x 0.2965 = $2,490.60. The employer saves its own payroll tax of 7.65% on the same amount, or $8,400 x 0.0765 = $642.60, so the arrangement costs the employer nothing and returns a saving.Case study
Seen in the real world
Larkspur Dental Group is a fictional practice with 60 employees that had been paying health premiums after tax for years. The practice manager priced a cafeteria plan and found that employees would elect an average of $4,200 each, giving total elections of 60 x $4,200 = $252,000.
The employer payroll tax saving alone came to $252,000 x 0.0765 = $19,278 a year. Third-party administration was quoted at $4,800 annually, leaving a net gain of $19,278 - $4,800 = $14,478 for the practice, with employees separately keeping several hundred dollars each in reduced tax.
The first year was not entirely smooth in this illustrative example. Several employees over-elected into medical flexible spending accounts and forfeited unused balances, so the practice added a short enrolment briefing and a spending estimator before the second year, after which forfeitures dropped sharply.
Watch out
Common mistakes
- Treating the election as adjustable during the year, when changes are generally permitted only at enrolment or after a qualifying life event such as marriage or the birth of a child.
- Over-electing into a flexible spending account on the assumption that leftover money rolls over indefinitely, when unused amounts beyond any permitted carryover are forfeited.
- Skipping the non-discrimination tests in a small company, which can strip the tax benefit from exactly the owners and senior staff the plan was expected to help most.
Questions
People also ask
What benefits can be offered through a cafeteria plan?
Commonly health insurance premiums, health savings account contributions, medical and dependent care flexible spending accounts, group term life cover within limits and some disability policies.
Does the employer save money too?
Yes, because pre-tax elections reduce total taxable wages, which lowers the employer's payroll tax bill by roughly 7.65% of the amount elected in the United States.
Can an employee change an election mid-year?
Only after a qualifying life event, such as marriage, divorce, a birth, adoption or a significant change in a spouse's employment or benefits.