Section 125 Cafeteria Plans: How Pre-Tax Benefits Work

A Section 125 cafeteria plan lets employees pay for certain benefits with pre-tax pay. The most common example is an employee's share of health insurance premiums. Flexible spending arrangements (FSAs) for medical or dependent care costs are run through the same kind of plan.

For a small employer, a cafeteria plan can be one of the simpler benefits to add, but the tax break depends on following the rules. The plan has to be in writing, elections generally have to stay fixed for the year, and the plan can't favor owners and higher earners.

This is general information, not tax or legal advice. Dollar limits change every year. Confirm the current figures in IRS Publication 15-B and work with a CPA, enrolled agent or benefits attorney when you set up or change a plan.

What a cafeteria plan is

The IRS defines a cafeteria plan as "a separate written plan maintained by an employer for employees" that meets the requirements of section 125 of the Internal Revenue Code. Participants must be able to choose between at least one taxable benefit, such as cash, and at least one qualified benefit. According to the IRS, a section 125 plan is the only way an employer can offer that choice without the choice itself making the benefits taxable.

Here is how it works in practice. An employee signs a salary reduction agreement, and that portion of pay goes toward qualified benefits. The IRS explains that these salary reduction contributions are not treated as wages for federal income tax, and generally are not subject to Social Security, Medicare (FICA) or federal unemployment (FUTA) taxes.

What can and can't go in the plan

IRS Publication 15-B (2026) lists the qualified benefits a cafeteria plan can include:

• accident and health benefits, but not Archer medical savings accounts or long-term care insurance
• adoption assistance
• dependent care assistance
• group-term life insurance coverage
• health savings accounts (HSAs)

The same publication lists benefits a cafeteria plan can't include. Among them are educational assistance, employee discounts, meals, transportation (commuting) benefits, athletic facilities, de minimis benefits and retirement planning services. The IRS also notes that a cafeteria plan generally can't offer benefits that defer pay, though a qualified 401(k) plan is an exception.

Health and dependent care FSAs

An FSA is a cafeteria plan benefit funded by salary reduction. It reimburses employees for eligible costs. Key rules from the IRS:

• Health FSA limit. For plan years beginning in 2026, IRS Publication 15-B says a cafeteria plan may not allow an employee to request salary reduction contributions to a health FSA of more than $3,400. A plan that doesn't impose the limit isn't a cafeteria plan, and all of its benefits become taxable.
• Dependent care. For the 2026 tax year, Publication 15-B says the annual dependent care FSA limit was raised from $5,000 to $7,500, or from $2,500 to $3,750 for married people filing separately.
• Use-or-lose. FSAs are subject to an annual use-or-lose rule. Publication 15-B explains that, instead of a grace period, an employer may amend the plan to let unused health FSA amounts carry over to the next plan year. For plan years beginning in 2026, IRS Revenue Procedure 2025-32 caps the carryover at $680, and the cap changes yearly.
• No advance payments. The IRS says employees can be reimbursed only for documented expenses incurred during the plan year, after they are substantiated.

Put it in writing, and keep elections fixed

The written plan is not optional. The IRS says it "must specifically describe all benefits and establish rules for eligibility and elections." The Treasury and IRS proposed cafeteria plan regulations (published August 6, 2007) add that the plan must state how contributions are made, the maximum amount of elective contributions and the plan year. It must also provide that elections are irrevocable, except where the plan adopts the optional change-in-status rules.

In practice, employees choose before the plan year starts and generally can't change their minds mid-year. An employer that wants to allow mid-year changes for events like marriage or a birth must write those change-in-status rules into the plan. The proposed regulations list allowing mid-year changes outside those rules among the reasons a plan would fail section 125 and stop being a cafeteria plan.

For example, imagine a 12-person accounting office that has employees pay their share of health premiums with pre-tax pay. If someone asks to stop their deduction in July because money is tight, the office can only allow it if a permitted change-in-status event applies and the written plan includes that rule.

Who can participate

Publication 15-B treats current common-law employees as employees for cafeteria plan purposes, along with certain full-time life insurance agents and long-term leased employees. The publication says a 2 percent shareholder of an S corporation is not treated as an employee for this purpose. The IRS also explains that a plan may provide benefits to employees' spouses and dependents, and may cover former employees, but it can't exist mainly for former employees.

Nondiscrimination and the simple cafeteria plan

A cafeteria plan can't favor highly compensated or key employees. Publication 15-B (2026) explains the consequences. If the plan favors highly compensated employees, the value of the taxable benefits they could have chosen goes into their wages. Under the publication, a plan also favors key employees if more than 25 percent of the plan's nontaxable benefits go to them. For 2026, the publication defines a key employee generally as an officer with annual pay over $235,000, a 5 percent owner, or a 1 percent owner with annual pay over $150,000.

Small businesses have another option: a simple cafeteria plan, which is treated as meeting the nondiscrimination requirements. Publication 15-B (2026) describes the conditions:

• Eligibility. You employed an average of 100 or fewer employees during either of the 2 preceding years.
• Participation. Generally, all employees with at least 1,000 hours of service in the preceding plan year must be eligible. Certain groups, such as employees under 21 or with less than one year of service, can be excluded.
• Employer contribution. You must contribute either a uniform percentage of at least 2 percent of pay, or the lesser of 6 percent of pay or twice the employee's salary reduction.

Filing and paperwork

The IRS says a cafeteria plan alone generally has no Form 5500 filing requirement. The health plan or other welfare benefits it pays for may still have their own Department of Labor reporting duties. See our guide to ERISA plan documents and SPDs for those rules, and our guide to nondiscrimination and HIPAA privacy for how other nondiscrimination tests apply.

Key takeaways

• A Section 125 plan lets employees pay for qualified benefits, such as health premiums and FSAs, with pre-tax pay, but only under a written plan.
• For plan years beginning in 2026, IRS Publication 15-B caps employee salary reductions to a health FSA at $3,400. For the 2026 tax year, it puts the dependent care FSA limit at $7,500.
• Elections are generally fixed for the plan year. Mid-year changes are allowed only if the plan adopts the IRS change-in-status rules.
• Plans can't favor highly compensated or key employees. Eligible small employers can use a simple cafeteria plan to meet those tests.
• Confirm each year's limits in the current Publication 15-B before open enrollment.

Sources

• Internal Revenue Service, Publication 15-B (2026), Employer's Tax Guide to Fringe Benefits
• Internal Revenue Service, Revenue Procedure 2025-32 (2026 inflation adjustments)
• Internal Revenue Service, FAQs for government entities regarding cafeteria plans
• Department of the Treasury and Internal Revenue Service, Employee Benefits — Cafeteria Plans, proposed regulations, Federal Register (August 6, 2007)