What Is a Section 125 Plan?

A Cafeteria Plan, formally known as a Section 125 Plan, is an employer-sponsored benefit arrangement that allows employees to choose among certain benefits and pay for them with pre-tax dollars. The concept is simple: instead of receiving all compensation as taxable cash, employees may elect to redirect a portion of their pay toward qualified benefits, such as health insurance premiums or flexible spending accounts, before taxes are applied.

The name “cafeteria plan” comes from the idea of choice. Employees are not forced into a single benefits structure. Instead, they select from a menu of available options based on their personal needs, family situation, and financial priorities.

How a Section 125 Plan Works

Under a Section 125 Plan, employees make benefit elections for a plan year, typically during open enrollment. Some elections allow compensation to be excluded from taxable income, while others may be made on an after-tax basis.

A simple example helps illustrate the mechanics:

An employee earns $60,000 per year. Through the Section 125 Plan, they elect to direct $3,000 toward health insurance premiums and $2,000 toward a dependent care flexible spending account. Because those elections are made on a pre-tax basis, the employee is taxed on $55,000 instead of $60,000.

This tax treatment is only permitted because Section 125 of the Internal Revenue Code allows employees to choose benefits in lieu of cash compensation, provided the plan complies with IRS rules [1].

Benefits Commonly Offered Through a Section 125 Plan

A Section 125 Plan does not create benefits by itself. Instead, it acts as the funding and tax mechanism for certain benefits the employer already offers. Common examples include medical, dental, and vision insurance premiums, health and dependent care flexible spending accounts, and employee contributions to health savings accounts.

While the plan offers flexibility, not every benefit qualifies for pre-tax treatment, and not every benefit offered by an employer must be included in the Section 125 Plan. Proper plan design and documentation determine what fits and what does not.

Why Employers Use Section 125 Plans

The appeal of a Section 125 Plan is often framed around tax savings, and that is certainly part of the story. Employees benefit from lower taxable income, while employers reduce payroll tax liability because pre-tax elections reduce taxable wages.

But tax efficiency is not the only reason these plans are widely used. Section 125 Plans also give employers a way to offer meaningful choice while managing costs. Rather than guessing which benefits employees value most, employers can offer a structured set of options and allow employees to decide how to allocate their compensation.

That flexibility, however, comes with responsibility.

Where Decision-Making and Fiduciary Risk Enter the Picture

One of the most overlooked aspects of Section 125 Plans is how closely they are tied to employee decision-making. When employees choose benefits, they are often navigating complex tradeoffs involving premiums, deductibles, coverage levels, and out-of-pocket risk.

As Jed Cohen has pointed out, simply offering choice is not enough if those choices are poorly designed or inadequately explained. When employees are presented with confusing or overpriced options, many will choose coverage that costs more than necessary or fails to meet their needs, undermining the very purpose of the benefit [3].

This concern is no longer theoretical. The Department of Labor has made clear that employers are fiduciaries with respect to the health, dental, and vision plans they sponsor, and that fiduciary responsibility includes helping participants make informed decisions [4]. A Section 125 Plan is often the vehicle through which those decisions are executed, which places it squarely within the broader benefits governance framework.

The Importance of Documentation and Administration

From a technical standpoint, Section 125 Plans are governed by IRS rules, not ERISA. Even so, they must be established and operated pursuant to a written plan document that outlines eligibility, benefits, election procedures, and plan terms [2].

Failing to maintain proper documentation or operate the plan as written can jeopardize the plan’s tax-favored status. Elections made outside permitted windows, skipped nondiscrimination testing, or inclusion of ineligible benefits can all create compliance problems.

More subtly, poor administration can amplify fiduciary risk. When elections are unclear or communications are inconsistent, employees are more likely to make suboptimal choices, which in today’s enforcement and litigation environment can draw scrutiny.

A Cautionary Note for Employers

Many employers treat Section 125 Plans as background infrastructure, something that runs quietly through payroll year after year. That approach worked for a long time. It is increasingly risky today.

As recent fiduciary litigation has shown, courts and regulators are paying closer attention to benefit design, pricing, and oversight. Employers may face claims not just for technical failures, but for failing to act prudently when structuring and communicating benefit choices, even when those choices are employee-driven.

As Cohen notes, fiduciary responsibility does not end with offering options. It includes ensuring those options are reasonable, well-vetted, and supported by clear information [3].

Best Practices for Section 125 Plans

Although Section 125 Plans themselves are tax arrangements, the benefits that flow through them often carry fiduciary obligations. Employers should approach these plans with the same discipline applied to retirement plans or other major benefit programs.

That includes reviewing plan design regularly, comparing the cost and value of available options, providing employees with clear and usable information, and documenting decisions. The goal is not to eliminate choice, but to ensure that the choices presented are thoughtful, defensible, and aligned with employees’ best interests.

Conclusion

A Section 125 Plan is more than a payroll convenience. It is the structural backbone that supports pre-tax benefits, employee choice, and significant financial outcomes for both employees and employers. When properly designed and administered, it enhances flexibility and efficiency. When neglected, it can quietly become a source of tax exposure and fiduciary risk.

Offering a cafeteria-style menu is only the first step. Employers must also pay attention to what is being served, how it is explained, and how decisions are made.

References

1. Legal Information Institute. (n.d.). 26 U.S. Code § 125: Cafeteria plans. Cornell Law School. https://www.law.cornell.edu/uscode/text/26/125
   
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/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