Cafeteria Plans – The Basics

By Venbrook Compliance Connection • 29 Sep 2026 • 9 min read

A cafeteria plan, sometimes referred to as a §125 plan, allows employees to choose between taxable compensation and certain qualified benefits. Employees who elect qualified benefits may generally pay for those benefits on a pre-tax basis, reducing taxable income and, in many cases, employment taxes for both the employee and employer. Cafeteria plans may be offered by employers of any size and allow eligible employees to pay for certain benefits on a pre-tax basis for themselves, their spouses, and eligible tax dependents.

To preserve these tax advantages, however, employers must comply with various §125 requirements, including maintaining a written plan document, following applicable election and election change rules, and satisfying nondiscrimination requirements. Failure to comply with these requirements, or to operate the plan in accordance with its written terms, may result in the loss of favorable tax treatment for some or all participant elections.

Types of Cafeteria Plans

There are two basic types of cafeteria plans – (i) a premium only plan (POP), which is limited solely to employee contributions toward monthly insurance premiums; and (ii) a full cafeteria plan, which can include contributions toward monthly insurance premiums as well as many other benefits.

PREMIUM ONLY PLAN (POP)	FULL CAFETERIA PLAN
Employee contributions toward monthly insurance premiums, such as medical, dental, vision or life insurance.	Employee contributions toward monthly insurance premiums, plus other benefits such as health FSAs, DCAPs, and HSAs.

POP plans are simpler and, in some cases, are subject to less stringent compliance requirements (e.g., a special safe harbor under the §125 nondiscrimination rules), while a full cafeteria plan offers more opportunities for employees to take advantage of tax-favored benefit options.

Written Plan Document

To offer benefits through a cafeteria plan, an employer must maintain a written §125 cafeteria plan document that is formally adopted on or before the first day of the plan year in which it is effective.

The §125 written plan document requirement is separate from ERISA's plan document requirements. While employer-sponsored welfare benefit plans offered through a cafeteria plan are often subject to ERISA, the cafeteria plan itself must independently satisfy the written plan requirements under Internal Revenue Code §125. Accordingly, employers often maintain both ERISA-related plan documentation and a separate written §125 cafeteria plan document to satisfy the applicable requirements of each law.

The cafeteria plan document should be sufficiently detailed to reflect how the plan actually operates and is administered in accordance with its written terms. At a minimum, the document should address the items outlined in the table below.

Cafeteria (§125) Plan Document Content Requirements
Eligibility and Participation	Definition of eligible employees Any excluded employee groups Applicable waiting periods or entry dates
Benefits Offered	Description of each qualified benefit available through the plan
Election Procedures	Rules for initial elections Annual election and open enrollment procedures Effective dates of elections
Election Change Rules	Permitted mid-year election changes Timing for making mid-year election change requests
Contribution Structure	Employee salary reduction contributions Employer contributions, if any How contributions may be allocated among available benefits
Plan Year	Clearly defined plan year of 12 months or less
FSA Provisions (if applicable)	Uniform coverage rule for health FSAs Use-it-or-lose-it rule and any grace period or carryover feature Claims and reimbursement procedures Maximum benefit/reimbursement limits
Administration	Identification of the plan administrator Procedures for administration and operation of the plan Amendment/termination authority

Who Can Participate?

Employers may establish eligibility requirements, such as limiting participation to full-time employees or requiring satisfaction of a waiting period, provided those requirements are applied consistently and reflected in the written plan document. However, cafeteria plan participation is generally limited to common-law employees and certain former employees.

Individuals who are not treated as employees generally cannot participate in a cafeteria plan on a tax-favored basis. This includes independent contractors, owners, and non-employee members of a board of directors. For this purpose, “owners” generally include sole proprietors, partners in a partnership, and >2% S-Corp shareholders. C-Corp shareholders who are also employees (dual status) are allowed to participate to the extent of their W-2 income.

What Can Be Offered Through a Cafeteria Plan?

Employers have flexibility in selecting benefits, but not every benefit may be provided on a tax-favored basis, and some benefits cannot be included at all. The following summarizes the categories:

Generally Eligible for Tax-Favored Treatment

Accident and health insurance, AD&D, adoption assistance, HSAs, health FSAs, DCAPs, Trump Account contribution programs, and certain retirement plan contributions (e.g., 401(k) deferrals) can all be run through a cafeteria plan and qualify for tax-favored treatment.

Eligible, but Tax Treatment May Be Limited

Group term life insurance may be offered through a cafeteria plan. However, employer-provided coverage exceeding $50,000 may result in taxable imputed income to the employee.

Premiums for disability, fixed indemnity and specified disease coverage may generally be paid through a cafeteria plan; however, using employer or pre-tax employee contributions can cause such benefits received by the employee to be taxable. For that reason, employers often collect employee contributions on an after-tax basis when tax-free benefits are desired.

Not Eligible for Tax-Favored Treatment

Scholarships and education assistance, employer-provided meals and lodging, qualified transportation benefits, long-term care insurance, HRAs, Archer MSAs, spousal or dependent life insurance, and 403(b) contributions cannot be run through a cafeteria plan.

Funding

Employees participating in the cafeteria plan make a choice between taxable and non-taxable benefits. Through an annual election process, employees may choose to apply some of their taxable compensation toward benefits offered through the employer’s cafeteria plan (i.e. salary reductions); if the benefits qualify for tax-favored status, then the employee and employer save some money on taxes while also providing benefits for the employee. Cafeteria plan elections and contributions generally apply to benefits for the applicable plan year. Certain benefits, particularly including FSAs, are subject to specific rules governing unused amounts, including permitted grace periods or carryovers.

Cafeteria plan contributions may come solely from employee salary reductions but could also involve employer contributions (e.g. flex credits or defined contribution that can be used toward qualified benefits offered through the cafeteria plan and, if not used for benefits, may be available as taxable cash compensation).

Participant Elections & Mid-Year Changes

Employees generally make cafeteria plan elections when first eligible and at least annually thereafter for each plan year. Once made, a pre-tax election is generally irrevocable for the plan year unless the employee, spouse, or dependent experiences a change in status or life event recognized under the §125 rules and the plan permits the corresponding change.

Prospective Elections Are the General Rule

Cafeteria plan elections generally must operate prospectively; they should affect future payroll and pay for future coverage. There are limited exceptions, including enrollment elections made within 30 days of hire and elections associated with the birth, adoption, or placement for adoption of a child.

Common Events That May Permit a Mid-Year Change

There are many different circumstances that will permit a mid-year change in an employee’s elections, but participants cannot voluntarily increase, decrease or revoke elections as desired without experiencing a recognized mid-year election change event. Some of the most common events include:

Change in marital status or number of dependents;
Change in employment status affecting eligibility;
Medicare or Medicaid entitlement or loss of eligibility;
Change in cost of coverage;
HIPAA special enrollment rights; and
Enrollment in Marketplace coverage and certain other health coverage.

A permitted election change must also satisfy any applicable consistency requirement. In many cases, this means the requested change must be “on account of and corresponding to” the event. Importantly, §125 generally permits a plan to allow qualifying mid-year changes; it does not require the employer to allow every change permitted by the regulations. The plan document may be more restrictive and should specify which election changes are available, but many plans are drafted to permit all mid-year changes permitted under §125 rules.

Nondiscrimination Rules

§125 prohibits cafeteria plans from discriminating in favor of highly compensated or key employees with respect to eligibility, benefits, or employer contributions. To determine compliance, cafeteria plans are generally tested for nondiscrimination annually. The testing evaluates whether a sufficient number of non-highly compensated employees are eligible to participate and whether benefits and contributions are available on a substantially similar basis. Eligibility structures, contribution arrangements, or benefit designs that disproportionately favor highly compensated or key employees may result in a testing failure.

A failure of the §125 nondiscrimination rules does not generally disqualify the entire cafeteria plan. Instead, highly compensated or key employee participants may lose the favorable tax treatment associated with some or all of their cafeteria plan benefits, resulting in additional taxable income and related payroll tax consequences.

Separate Nondiscrimination Rules May Apply

While §125 applies to the cafeteria plan itself and will test the benefits offered through the cafeteria plan in aggregate, certain underlying benefits offered through the cafeteria plan may also be subject to separate nondiscrimination rules. For example: