A cafeteria plan is a separate written plan that meets the specific requirements and regulations of Section 125 of the Internal Revenue Service Code, and is maintained by an employer for employees.
As suggested by the name, a Cafeteria Plan allows employees to choose where their benefit dollars will be spent. Employees enrolled in a Cafeteria Plan must be permitted to choose at least one taxable benefit (such as cash or payment for annual leave) and one qualified benefit.
The Cafeteria Plan must specifically describe all taxable and qualified benefits offered, and establish rules for eligibility and elections. The plan can offer a number of qualified selections, including medical, accident, disability, vision, dental, group term life insurance, adoption assistance, dependent care assistance, and health savings accounts, including distributions to pay long-term care services. It can reimburse actual medical expenses and pay children's day care expenses. Pre-tax earnings are used to pay for these benefits.
Cafeteria Plans allows employees to choose the benefits most important to their individual situations. Each employee must estimate the costs that he or she will incur during the plan's upcoming year, and request that the estimated amount be deducted from wages and deposited into the Cafeteria Plan.
It is highly recommended that smaller companies opting to offer a Cafeteria Plan use a Third Party Administrator (TPA) since the administration of these plans is intricate, and if mistakes are made, the fines for non-compliance could be significant.
A Section 125 Cafeteria Plan is the only way an employer can offer employees a choice between taxable and nontaxable benefits without that choice in benefits becoming taxable. A plan offering only a choice between taxable benefits with no qualified benefits offered is not a Section 125 Cafeteria Plan.
Every written plan must specifically describe the benefits offered and establish rules for eligibility and elections. According to the IRS Code, "Employer contributions to the cafeteria plan are usually made pursuant to salary reduction agreements between the employer and the employee in which the employee agrees to contribute a portion of his or her salary on a pre-tax basis to pay for the qualified benefits".
Be aware that Archer medical savings accounts or some long-term care insurance may not be considered "qualified" and it may be required that these be paid in "post tax" dollars.
Cafeteria Plan benefits may be offered not only to employees, but their spouses and dependents, as well. In some cases a plan may also allow former employees to be included, but cannot exist for that purpose only.
Employers also benefit from offering a Cafeteria Plan to their employees. It may appear on the surface that it is costly for the employers to offer these plans, but on closer inspection, the benefits become clear. Any employee enrolled in the program can have up to $5000 per year deducted from earnings and deposited into the account. If the employee spends all the money in their plan, they won't be able to use the plan for the rest of the year. However, any money left in the plan at the end of the year reverts to the employer. This does require more work on the part of the employer under Section 125 administration of the plan, but employers often use this money to help pay for the administration of the plan. The employer also receives a tax savings throughout the year, which in turn helps to pay for the plan.