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How Section 125 cafeteria plans work

Written by: Josh Miner
December 22, 2020 at 11:33 AM

Many working Americans have access to a Section 125 Cafeteria Plan at some point during their working career, yet many do not take full advantage of them. When utilized correctly, a cafeteria plan can increase take-home-pay without any change in expenditures. This article provides an overview of how Section 125 cafeteria plans work.

What is a Section 125 cafeteria plan?

A "cafeteria plan" (see Section 125 of the IRS Code) is a benefit provided by an employer which allows an employee to contribute a certain amount of his or her gross income to a designated "account" before taxes are calculated. This "account" can be used to reimburse the employee for certain types of insurance premiums, medical, or dependent care expenses throughout the plan year or claim period as the employee incurs qualified expenses.

Essentially, a Section 125 cafeteria plan allows an employee to reduce the gross income amount used to calculate Federal, Social Security, and some State taxes. This amounts to a savings of between 25% and 40% of every dollar they contribute to the plan. The employer also realizes savings on FICA withholding tax for each participating employee.

How does the Affordable Care Act affect Section 125 cafeteria plans?

The Affordable Care Act limited the type of health insurance premiums that may be used with a Section 125 cafeteria plan. Specifically, Federally Facilitated Marketplace plans are not a qualified benefit under Section 125 (plans on Healthcare.gov or state exchanges). Because of this change, most employers now use Section 105 Plans for individual health insurance policies.

Read more: Section 105 plans made easy.

Common examples of Section 125 cafeteria plans:

Download this comparison chart: HRA vs HSA vs.FSA.

Conclusion

Section 125 plans give people the ability to save significantly on taxes used for eligible expenses. However, there are some limitations and differences between the two. Section 105 plans are a great alternative for people looking to save tax dollars on individual health insurance.

Learn whether an HRA or HSA is right for you.

This post was originally published on July 14, 2014. It was last updated on December 22, 2020.

Topics: Section 125, Flexible Spending Accounts, Health Savings Accounts

Additional Resources

See what makes HRAs different from HSAs and FSAs in our comparison chart.
Did you know you can use an HRA and HSA together? See how in our guide.

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