What Is a Section 125 Cafeteria Plan and Who Qualifies?

A payroll manager pulls up this month’s numbers and notices two employees with the exact same salary owe different amounts in tax. One signed up for the company’s health FSA. The other didn’t. That gap isn’t a mistake. It’s Section 125 doing exactly what it was built to do.

A Section 125 cafeteria plan is a written benefits plan authorized under Section 125 of the Internal Revenue Code. It lets employees choose between cash, which is taxable, and certain qualified benefits, which are not. Health insurance premiums, flexible spending accounts, and HSA contributions are the choices employees pick most often. Because that money comes out of pay before taxes are calculated, both the employee and the employer end up owing less.

Last updated: August 2026.

What Is a Section 125 Cafeteria Plan Under the IRS Code?

The name comes straight from the tax code. IRS Publication 15-B describes a cafeteria plan as a written plan that allows employees to choose between receiving cash or taxable benefits, instead of certain qualified benefits for which the law provides an exclusion from wages. Picture an actual cafeteria line: employees pick from a set menu of pretax options instead of taking a flat cash payment.

Employers usually build this around a Premium Only Plan, or POP, which simply lets employees pay their share of health insurance premiums with pretax salary. A full flex plan goes further and adds flexible spending accounts, dependent care assistance, and other qualified benefits to the menu. Either way, the plan has to exist in writing before any pretax election can happen. No exceptions there.

Why a Cafeteria Plan Lowers Payroll Taxes for Everyone

Here’s the part that gets an employer’s attention. Money an employee routes through a cafeteria plan never counts as taxable wages. According to IRS guidance, qualifying cafeteria plan contributions are generally exempt from federal income tax withholding, Social Security, Medicare, and FUTA taxes when the plan is properly structured.

That’s a real number, not a theoretical one. Social Security and Medicare taxes, known together as FICA, add up to 7.65% on both sides of the paycheck: the employee pays half, and the employer matches it. That adds up fast. When $2,400 a year moves through a health FSA instead of showing up as regular wages, the employee avoids federal income tax on it plus their share of FICA. The employer avoids the matching FICA and, in most cases, FUTA on that same amount.

Multiply that across fifty or a hundred employees enrolled in a POP or FSA, and the employer side of the savings stops being a rounding error. That’s one reason Section 125 plans show up so often in employee benefits packages at companies of every size, not just large enterprises.

Which Employers Can Offer a Section 125 Plan?

Most employers can sponsor one. Corporations, partnerships, LLCs, and nonprofit organizations can all set up a cafeteria plan for their common-law employees. There’s no special license required and no minimum company size to qualify.

Ownership status matters more than company type, though. Why does that matter? Because the IRS treats certain owners as ineligible to participate as employees under the plan, even when their own company sponsors it. A shareholder who owns more than 2% of an S corporation, for example, isn’t treated as an employee of that corporation for cafeteria plan purposes, according to IRS Publication 15-B. Self-employed individuals and partners in a partnership fall into a similar bucket: they aren’t common-law employees, so they generally can’t run their own elections through the business’s plan, even though the business can still sponsor one for its staff.

For rank-and-file W-2 employees, none of that matters. Eligibility questions for them come down to whether they’re a highly compensated or key employee, which is a separate question covered below.

What Benefits Can You Include in a Cafeteria Plan?

A cafeteria plan can’t offer just anything pretax. The IRS limits qualified benefits to a defined list. The benefits employers include most often are:

• Health insurance premiums (accident and health benefits) through a Premium Only Plan
• Health flexible spending accounts (FSAs) for out-of-pocket medical costs
• Dependent care assistance, typically structured as a dependent care FSA
• Health Savings Account (HSA) contributions for employees enrolled in a qualifying high-deductible health plan
• Adoption assistance programs
• Group-term life insurance coverage

A few benefits are specifically excluded, even though they sound similar. Archer MSAs and long-term care insurance can’t be run through a cafeteria plan. Neither can de minimis fringe benefits, educational assistance, employee discounts, meals, transportation benefits, tuition reduction, or working condition benefits. Those either follow their own separate tax rules or simply don’t qualify for Section 125 treatment.

Contribution limits also matter here. For 2026, the IRS capped health FSA contributions at $3,400 and raised the dependent care FSA limit to $7,500 ($3,750 for employees who are married and filing separately). Those numbers change often. Check them every year before open enrollment.

Nondiscrimination Testing: Keeping the Plan Fair

A cafeteria plan can’t just benefit the people at the top of the org chart. The IRS requires the plan to pass nondiscrimination testing so it doesn’t favor highly compensated employees or key employees over everyone else.

A highly compensated employee, for cafeteria plan purposes, includes an officer, a shareholder who owns more than 5% of the company’s voting power or stock value, an employee who is highly compensated based on the facts and circumstances, or a spouse or dependent of any of those people. A key employee is defined a bit differently. For 2026, that’s an officer with annual pay over $235,000, a 5% owner of the business, or a 1% owner whose pay tops $150,000.

If a plan’s eligibility rules, contributions, or benefits favor highly compensated employees, or if key employees receive too large a share of the plan’s nontaxable benefits, the consequences land on those specific employees. They lose the pretax treatment. The value of the taxable benefit they could have chosen instead gets added back into their wages, per IRS guidance.

That’s a narrow penalty. It’s still one worth avoiding. Running the test once a year, rather than assuming a small plan is automatically fine, is usually the difference between a clean audit and an uncomfortable call with a tax advisor.

Setting Up and Administering a Cafeteria Plan

Every cafeteria plan starts with a written plan document. That’s not optional. The IRS definition itself requires the plan to exist in writing before employees can make an election.

Once elections are locked in for the plan year, they generally stay that way. IRS guidance (Notice 2014-55) describes specific situations, such as certain changes in employment status, where a participant is allowed to revoke or change a cafeteria plan election mid-year. Outside of those permitted events, employees live with what they picked at open enrollment.

Unused FSA money used to simply disappear at year-end under the use-or-lose rule. Employers now have the option to build in a carryover instead, letting employees roll a portion of unused contributions into the next plan year rather than forfeiting it outright.

None of this runs itself. Between the written plan document, the annual nondiscrimination testing, and payroll deductions that need to land correctly on every check, a lot of moving parts have to line up. That’s typically handled through payroll and tax software connected to the company’s HR and benefits systems, so elections, deductions, and testing data stay in one place instead of scattered across spreadsheets.

Frequently Asked Questions

Disclaimer: This article is for general informational purposes only and does not constitute tax or legal advice. Section 125 plan rules are complex and IRS guidance can change. Consult a tax advisor or benefits counsel before establishing or administering a cafeteria plan.

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