A cafeteria plan is one that gives employees the option to pick from a variety of benefits. The cafeteria selection must include at least one taxable benefit, such as cash. It also has to offer benefits that aren't taxable, such as dependent-care insurance. If one of the benefits is health insurance, any money the insurer pays you may be taxable.
Being in a cafeteria plan doesn't determine by itself whether your settlement is taxable. What matters is whether the premiums are included in your income. If they are, your benefits aren't taxable. If the employer excludes the costs of premiums from your salary, 100 percent of the settlement may be taxable. If a percentage of the premiums counts as salary, the same percentage of benefits is tax-free when the insurer pays out.
The big exception to taxability is money that goes to pay off your medical bills. Insurance checks that simply pay off the cost of cancer treatment -- whether it's surgery, chemo or radiation -- aren't taxable. The only effect they have on your taxes is that if you deduct medical costs, you can't write off bills the insurer pays for. Otherwise, only money you get over and above your medical expenses is potentially taxable income.
Some cafeteria plans also allow your family to buy in and select benefits for themselves. If you have family members who don't have this option -- it doesn't extend to domestic partners or their children from past relationships, for instance -- they can still enjoy the benefits if you buy a family plan that covers them too. The same rules apply in deciding whether benefits are taxable. If they don't come out of your income, tax kicks in.
Report any taxable benefits on your Form 1040 as Other Income. You don't have to report any of your tax-free benefits, such as reimbursements for your medical bills. If you have any cancer costs that weren't reimbursed -- this is true for any medical bills -- you can report them as itemized deductions on Schedule A. You add up your total deductible medical expenses for the year and subtract 10 percent of your adjusted gross income. Whatever remains is the write-off.