Internal Revenue Service Section 125 plans are more commonly referred to as cafeteria plans. Section 125 refers to the section of the Internal Revenue Code in which the rules for cafeteria plans are set forth. Because a cafeteria plan is a creature of the tax code, there are special tax rules associated with them.
What is a Cafeteria Plan?
The Internal Revenue Code defines a cafeteria plan as a written plan under which all participants are employees and the participants may choose between two more benefits consisting of taxable benefits -- such as cash -- and nontaxable qualified benefits. A cafeteria plan does not provide benefits directly to employees, but is a conduit or flexible spending arrangement for employees to elect benefits and finance those choices.
What are Nontaxable Qualified Benefits?
Nontaxable qualified benefits are those benefits that are allowed to be offered through a cafeteria plan under federal law. Those benefits range from group term life insurance to 401k plan contributions to health insurance and health savings accounts. The most popular benefits in a cafeteria plan are usually dependent care savings accounts and health care related offerings, as well as retirement savings.
What Benefits are Not Allowed under a Cafeteria Plan?
A cafeteria plan will not qualify as such and will not receive the tax benefits if it offers certain nonqualified benefits. Federal law prohibits a cafeteria plan from offering scholarships, long-term care insurance, educational assistance programs, employer-provided meals and lodging and Archer medical savings accounts. Moreover, cafeteria plans may not provide for benefits that defer compensation, which is why cafeteria plans feature a “use-it-or-lose-it” feature that prevents participants from carrying over unused benefits from one plan year to the next.
Are Cafeteria Plans Exempt from Taxes?
Cafeteria plans are not wholly exempt from taxes. Because cafeteria plans offer employees a choice between taxable benefits, such as cash, and nontaxable benefits, such as healthcare, cafeteria plans are not fully exempt from taxes. The taxation of a cafeteria plan will depend on the elections made by the employee. Cafeteria plans, however, provide tax savings for both employers and employees alike. Employees elect benefits and finance them through salary reductions on a pre-tax basis. This allows employees to enjoy benefits and higher take-home pay. It also provides tax savings for the employer by lowering the taxable income of its employees thereby allowing the employer to save on payroll taxes, such as FICA, FUTA and depending on state law, state or local taxes.