What Is a Cafeteria Plan?

A Cafeteria Plan — formally known as a Section 125 plan — is an employee benefit program that allows workers to choose from a variety of pre-tax benefits, similar to how a customer might choose items in a cafeteria. Employees can tailor their benefits to best suit their personal needs by selecting among options like health insurance, dental and vision coverage, dependent care assistance, and even contributions to flexible spending accounts (FSAs).

Let’s break down what it is, why it matters, and what fiduciaries should know.

How It Works

Under a Cafeteria Plan, employees are given a “menu” of benefit options. Some of these options are pre-tax benefits, which means employees can pay for them using money that hasn’t been taxed yet — lowering their taxable income. Others may be after-tax benefits.

Here’s a simplified example:

• An employee earns $60,000 annually.

• They choose to direct $3,000 to their health insurance and $2,000 to a dependent care FSA through the cafeteria plan.

• That $5,000 is subtracted from their taxable income, so they only pay taxes on $55,000.

Plans must meet specific IRS guidelines to maintain this tax-advantaged status. Notably, the plan must pass certain nondiscrimination tests to ensure it doesn’t favor highly compensated employees or key executives over rank-and-file workers.

Why Employers Offer Cafeteria Plans

1. Tax Savings for Employees: Employees reduce their taxable income, which means they take home more of their pay.

2. Tax Savings for Employers: Because pre-tax dollars reduce an employee’s taxable wages, employers save on payroll taxes (like FICA).

3. Flexibility and Personalization: Employees can select benefits that match their family structure, health needs, and financial goals.

What Fiduciaries Should Know

Cafeteria plans touch a surprising number of compliance issues that can trip up well-meaning employers. While these plans are governed by IRS rules rather than ERISA, they often serve as the delivery vehicle for benefits that are ERISA-governed — like health insurance, dental, vision, and more. That’s where fiduciary responsibility comes in.

Here’s what plan sponsors must stay on top of:

• Proper Plan Documentation: Employers must adopt a formal written plan document detailing who is eligible, what benefits are available, and how elections work.

• Nondiscrimination Testing: These tests ensure the plan doesn’t disproportionately benefit highly paid employees. Failing to pass can jeopardize the tax-favored status of the plan.

• Election Timing: Elections must typically be made before the plan year begins and are irrevocable for the year unless a qualifying event (like marriage or birth of a child) occurs.

• Participant Communications: Like with 401(k) plans, employers must provide clear, timely information that allows employees to make well-informed choices. Failure to do so could invite scrutiny — and lawsuits — particularly if employees end up enrolled in expensive or inappropriate coverage options.

A Cautionary Note

Many employers treat Cafeteria Plans as set-it-and-forget-it. But improper administration — like failing to update elections properly, skipping nondiscrimination testing, or offering ineligible benefits — can lead to costly IRS penalties. Worse, in the current environment of increased transparency and fiduciary accountability, poor benefit design and oversight can open the door to litigation.

As we've seen in recent fiduciary lawsuits, failing to act in employees' best interests can result in claims of breach — even if the employer had good intentions.

“Employers are fiduciaries on the health, vision and dental plans they sponsor.” – Jed Cohen, Fiduciary In A Box

Fiduciary Best Practices for Cafeteria Plans

Even though Cafeteria Plans themselves aren’t governed by ERISA, the benefits offered through them usually are. That means fiduciary best practices apply:

• Review the plan design annually with your benefits advisor.

• Compare the pricing and value of plan options — including HSAs, FSAs, and high-deductible plans.

• Conduct employee education to ensure plan choices are understood and wisely made.

• Document the process — especially when making changes to vendor relationships or plan design.

Think of it this way: if your 401(k) plan offered overpriced, underperforming funds, you'd expect to be held accountable. The same goes for benefit plans that run through your cafeteria plan. Your responsibility doesn’t stop with offering choices — it includes ensuring those choices are smart, cost-effective, and in your employees' best interests.

Conclusion

A Cafeteria Plan is more than just a tax-saving mechanism — it's a flexible tool that, when well-managed, can enhance employee satisfaction and financial well-being. But it also comes with administrative and compliance strings attached. For employers looking to stay out of legal trouble and maximize value for their workforce, it’s not enough to offer a buffet. You have to make sure what’s on the table is fresh, healthy, and clearly labeled.

References:

1. Internal Revenue Service. (2023). Cafeteria Plans (Section 125 Plans). https://www.irs.gov/pub/irs-pdf/p969.pdf

2. U.S. Department of the Treasury. (2021). 26 CFR § 1.125 - Cafeteria plans. https://www.ecfr.gov/current/title-26/chapter-I/subchapter-A/part-1/subject-group-ECFRed2d6d4fef36f3e/section-1.125

3. Cohen, J. (2022). Allowing Employees to Overpay for Health Benefits Is Risky. Insurance Newsnet. https://insurancenewsnet.com/innarticle/allowing-employees-to-overpay-for-health-benefits-is-risky 

4. U.S. Department of Labor. (2021). Field Assistance Bulletin No. 2021-03. https://www.dol.gov/agencies/ebsa/employers-and-advisers/guidance/field-assistance-bulletins/2021-03