Understanding Section 125 Cafeteria Plans

 

October 11, 2019
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​A cafeteria plan, also known as a section 125 plan, is a written plan that offers employees a choice between receiving their compensation in cash or as part of an employee benefit. If taken as a benefit, the employee generally receives two tax advantages:

  1. Employee contributions toward cafeteria-plan benefits are made pre-tax.
  2. Employer contributions toward an employee's cafeteria-plan benefits are not taxed.

The tax savings for employees through the use of pretax dollars to pay for benefits can be substantial. For example, an employee who spends $200 a month in pretax dollars for benefits can, in effect, save $60, assuming about 30 percent of the $200 would have gone to federal, state and local income taxes and FICA (Federal Insurance Contributions Act), the taxes deducted for Social Security and Medicare.

The employer also saves on taxes: For each $200 a month that an employee sets aside, the employer saves about $15—the 7.65 percent of the employee's wages that the employer would otherwise pay for Social Security and Medicare. However, the employer's tax savings may be largely offset by the costs of implementing and maintaining a pretax cafeteria plan.

Any employer with employees who are subject to U.S. income taxes is eligible to sponsor a cafeteria plan. Employers can be C corporations, S corporations, LLCs, partnerships, governmental entities or sole proprietorships. However, nonemployees cannot participate in a cafeteria plan; this exclusion applies to partners in a partnership, members of an LLC and individuals who own more than 2 percent of an S corporation.


Getting Started
To establish a valid cafeteria plan, employers generally must:
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​Adopt a written plan document that governs plan administration.
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​ Make employee plan elections irrevocable, unless revocation is permitted by law.
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​Satisfy certain nondiscrimination requirements related to the benefits and contributions provided.

Types of Cafeteria Plans

  • Full flex plans, in which employers make contributions for all plan-eligible employees, and employees use those contributions to buy various benefits. Employees can then make pre-tax contributions toward any benefit that the employer contributions do not fully cover.

  • Premium-only plans (POPs), which allow employees to choose between receiving their full salary in cash or using a share of that salary to pay group insurance policy premiums on a pretax basis.

  • Simple cafeteria plans, which generally provide employers with 100 or fewer employees a safe harbor from certain plan nondiscrimination requirements in exchange for contributing to each eligible employee's benefits.

  • Flexible spending arrangements (FSAs), which allow employees to make contributions toward health care and dependent care expenses on a pretax basis.

Common Benefits Offered

  • Group health insurance.
  • 401(k) retirement plans.
  • Health savings accounts.
  • Health flexible spending arrangements.
  • Dependent care flexible spending arrangements.
  • Group term life insurance.
  • Group dental insurance.
  • Group vision insurance.
  • Group disability insurance.

For a full list of benefits, see IRS Publication 15-B.

Required Documentation

Several required documents are designed to ensure that a cafeteria plan is compliant with laws and regulations. Such documents include a master plan document and an adoption agreement (sometimes combined into one document) that detail the legal and employer-specific aspects of the employer's benefits plan, including the benefits that are offered, who is eligible to participate, the manner of contributions and other legal notices.

Most employee benefit plans are covered by the Employee Retirement Income Security Act (ERISA) and must also furnish a summary plan description (SPD). An SPD is a plain-English version of the master plan document and the adoption agreement, and it is meant to inform employees about the aspects of the flexible benefits plan. The SPD must be provided to all eligible employees. The plan documents must be updated and amended at least every five year to reflect any applicable plan changes or regulatory updates.

An insurance policy, coverage certificate or plan booklet received from the insurance carrier or third-party administrator will generally not satisfy the SPD or plan document requirement. While these documents often include detailed descriptions of the benefits available under the plan, they rarely include all required information, such as a named fiduciary or the procedures for amending the plan. One simple and cost-effective solution is the wrap document, a relatively simple document that "wraps around", or incorporates, the insurance policy, coverage certificate or plan booklet. The benefits available under the plan continue to be governed by the insurance policy, coverage certificate or plan booklet, while the wrap document supplements it with the information necessary to comply with ERISA. In effect, the wrap document fills the gaps left by insurance carriers and third-party administrators. See What is the difference between a plan document and a summary plan description?

Employers must ensure that the rules outlined in the plan document and SPD are followed. Failure to administer a plan in accordance with the written terms of the plan and the Internal Revenue Code can result in the loss of the benefits' pretax status.

Employers that utilize a third-party administrator (TPA) must maintain written medical privacy policies and procedures as required under the Health Insurance Portability and Accountability Act (HIPAA) and have a signed business associate agreement with the TPA. Medical privacy policies and procedures detail how and when an employer can use and disclose protected health information, and the business associate agreement details how and when the TPA can use or disclose protected health information. The TPA should be able to provide the necessary documentation for the plan documents, the medical privacy policies and procedures, and the business associate agreement. See Summary of the HIPAA Privacy Rule and Business Associate Contracts.

Election Changes

Editor's Note: Internal Revenue Service (IRS) notice 2020-29 provides for increased flexibility with respect to mid-year elections under a section 125 cafeteria plan during calendar year 2020 due to COVID-19. The notice applies to employer sponsored health coverage, health flexible spending arrangements (health FSAs) and dependent care assistance programs (DCAPs).  


Employees' cafeteria-plan elections are generally irrevocable until the beginning of the next plan year. However, a cafeteria plan may generally permit an employee to revoke an election and make a new one midyear due to any one of the following:

  • Change-in-status events, such as a change in marital status, number of dependents, residency or employment status.
  • Significant cost or coverage changes.
  • Special enrollment entitlement.
  • FMLA leave.
  • Medicare entitlement. 


Change-in-Status Events

The following life events can trigger a change-in-status event:

A change in an employee's marital status, including marriage, divorce, legal separation or annulment.

An increase or decrease in the number of dependents, including the birth of a child, the death of a dependent, adoption and placement for adoption

​A change in the employment status of the employee, employee's spouse, or employee's dependents, including the termination or commencement of employment, a commencement of or a return from an unpaid leave of absence, or a change in worksite.

An employee's dependent satisfies or ceases to satisfy eligibility requirements for coverage due to attainment of age, a change in student status or any similar circumstance.

​A change in the place of residence of the employee, spouse or dependent.

​A participating employee's reduction in work hours so that the employee is expected to average less than 30 hours of service per week. 

​A participating employee's becoming eligible for open or special enrollment in a plan offered through a health insurance marketplace.
The requested election change must be consistent with the change-in-status event. For example, if an employee gets divorced, the employee's election under the cafeteria plan to cancel health coverage for any individual other than his or her spouse involved in the divorce would fail to correspond with that change-in-status event.

Significant Cost or Coverage Changes

A cafeteria plan may permit an employee to change his or her election during a plan year if one of the following occurs:

  • The cost charged to an employee for a benefit significantly increases or decreases, including when the employee or his or her spouse or dependents become eligible for COBRA coverage.
  • A benefit is significantly curtailed, including curtailments that result in a loss of coverage or an increase in deductible, co-pay or out-of-pocket amounts.
  • A benefit option is added or improved.

Special Enrollment Entitlement

HIPAA allows employees and their spouses and dependents who initially declined group health insurance coverage during open enrollment to nonetheless participate in the group plan when certain circumstances occur. This is referred to as "special enrollment." When this happens, a cafeteria plan may allow the employees (and their spouses and dependents) to change their cafeteria-plan elections.

The following events trigger HIPAA special enrollment rights:


​Loss of eligibility for other group health coverage.

​Termination of employer contributions toward other group health coverage.

​Certain life events, including marriage, birth, adoption, or placement for adoption.

​Loss of coverage under a state Children's Health Insurance Program (CHIP) or Medicaid.

​Determination of eligibility for premium assistance under CHIP or Medicaid.

FMLA Leave

An employee taking leave under the federal Family and Medical Leave Act (FMLA) may be permitted to revoke an existing election of group health plan coverage during his or her FMLA leave period.

Medicare Entitlement

If an employee, spouse or dependent enrolled in a group health plan benefit becomes entitled to coverage under Medicare, a cafeteria plan may permit the employee to make an election change to cancel or reduce the coverage of that employee, spouse or dependent.

Additional exceptions may apply. For more information, contact the Internal Revenue Service at 1-800-829-4933.

Nondiscrimination Rules

Cafeteria plans are generally subject to the nondiscrimination requirements of Internal Revenue Code section 125. To satisfy the section 125 nondiscrimination requirements, a plan generally must fulfill the following three tests: 

  • Eligibility Test: The plan may not discriminate in favor of highly compensated individuals as to eligibility to participate.

  • Benefits and Contributions Test: The plan may not discriminate in favor of highly compensated participants as to benefits and contributions.

  • Key Employee Concentration Test: The nontaxable benefits provided to key employees may not exceed 25 percent of the nontaxable benefits provided for all employees under the cafeteria plan.

If a plan fails any of these nondiscrimination tests, the highly compensated participant or key employee participating in the plan will lose the favorable tax treatment of the cafeteria-plan benefit and must include in his or her gross income the value of the taxable benefit with the greatest value that the employee could have elected to receive. Participants who are not highly compensated or key employees will not lose their tax benefits and are not impacted by the failure of a plan to pass nondiscrimination testing.


Safe Harbors

Safe harbors for satisfying these nondiscrimination tests exist for simple cafeteria plans POPs meeting specific requirements. For more information on the safe harbor for POPs, see the 2007 proposed cafeteria plan regulations, which employers may rely on for guidance pending the issuance of final regulations.


Highly Compensated Individuals

For purposes of section 125, the term "highly compensated individual" means an individual who is:

  • An officer of the company.
  • A shareholder owning more than 5 percent of the voting power or value of all classes of the employer's stock.
  • Highly compensated (generally $125,000 in compensation and, if elected by the employer, in the top-paid 20 percent of employees).
  • A spouse or dependent of an individual described in the three bullet points above.


Highly Compensated Participants

For purposes of section 125, the term "highly compensated participant" means a highly compensated individual (see above) who is eligible to participate in the cafeteria plan.


Key Employees

For purposes of section 125, a key employee is generally an employee who is either of the following:

  • An officer of the company having annual pay of more than $180,000.

  • An employee who is either of the following:

    • A 5 percent owner of the business.

    • A 1 percent owner of the business whose annual pay is more than $150,000.

Due to the complexity of testing plans for compliance with the section 125 nondiscrimination rules, any employer that is considering offering health benefits to only certain classes of employees should seek the advice of a knowledgeable benefits attorney.

Simple Cafeteria Plans

Federal law allows certain small employers to establish so-called simple cafeteria plans that are automatically treated as satisfying the Internal Revenue Code's nondiscrimination requirements for cafeteria plans. To offer a simple cafeteria plan, an employer generally must satisfy three requirements:

  1. Employer size requirements.

  2. Employer contribution requirements. 

  3. Employee participation requirements.


Employer Size Requirements

Employers are generally eligible to establish a simple cafeteria plan if they employ an average of 100 or fewer employees during either of the two preceding years. However, if the business was not in existence throughout the preceding year, employers are eligible to establish a simple cafeteria plan if they reasonably expect to employ an average of 100 or fewer employees in the current year. In addition, if the employer establishes a simple cafeteria plan in a year that they employ an average of 100 or fewer employees, they are considered an eligible employer for any subsequent year as long as they do not employ an average of 200 or more employees in a subsequent year.


Employer Contribution Requirements

Employers must contribute toward the benefits of each plan-eligible employee in an amount equal to one of the following:

  • A uniform percentage—not less than 2 percent—of the employee's compensation for the plan year.
  • An amount that is at least 6 percent of the employee's compensation for the plan year, or twice the amount the employee contributes toward his or her cafeteria-plan benefits, whichever is less.

If the contribution requirements are met using the second option above, the employer's rate of contribution to any highly compensated individual or key employee cannot be greater than its rate of contribution to any other individual or employee.


Employee Participation Requirements

In general, employers must allow all employees who had at least 1,000 hours of service in the preceding plan year to participate in a simple cafeteria plan. However, employers may exclude from the plan employees who meet one of the following criteria:

  • Are under age 21 before the close of a plan year.
  • Have less than one year of service with the employer as of any day during the plan year.

In addition, each eligible employee must be able to elect any benefit available under the plan unless he or she is subject to a limitation that is applicable to all plan participants.

Additional requirements and exceptions may apply. For more on simple cafeteria plans, see IRS Publication 15-B.

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