A cafeteria plan, also called a Section 125 plan, must meet Section 125 of the Internal Revenue Code to allow you to pay for qualified benefits with pretax dollars. As a participant in your employer’s cafeteria plan, you get a tax break on qualified benefits. Most, but not all, wages deducted from your paycheck for a cafeteria plan are tax-exempt.
Cafeteria plans typically include flexible spending accounts and premium-only plans. The former may include dependent care and adoption assistance and health savings accounts that allow you to elect a specific amount of your wages to pay for those expenses. The latter include insurance plans such as medical, dental and vision; life, accident and disability insurance; and contributions to 401(k) plans.
Cash vs. Qualified Benefits
To figure whether wages for a cafeteria plan are tax-exempt, determine whether the benefit is taxable or nontaxable. A cafeteria plan is the only way your employer can offer you a choice between taxable and nontaxable benefits without your selection causing the benefit to turn taxable. If the plan allows you to choose only between taxable benefits, it’s not a cafeteria plan. Taxable benefits are also called cash benefits, and nontaxable benefits are called qualified benefits. Your benefit is treated as cash if you pay for it with after-tax dollars. For example, if you use your option in your cafeteria plan to buy personal disability income insurance, you’re purchasing it on a cash basis and your premiums are not tax-exempt. In this case, your premiums are after-tax. Qualified benefits are tax-exempt; under IRS regulations they meet the qualification for exclusion from gross wages, resulting in a tax break. In this case, your premiums are pretax.
Most qualified benefits offered under a cafeteria plan are exempt from federal income tax, Social Security tax and Medicare tax. However, wages deducted for 401(k) plans, adoption assistance and group-term life insurance that exceed $50,000 in coverage are subject to Medicare and Social Security taxes but not federal income tax.
Whether qualified benefits offered under a cafeteria plan are exempt from state and local income tax depends on state and local laws. For example, in Pennsylvania, only some wages paid toward a cafeteria plan are excluded from state income tax. This includes payments for coverage for sickness, hospitalization, disability or death, and strike pay; these benefits are exempt only to the extent allowed for federal income tax exclusion. In Alabama, however, federal treatment of cafeteria plans applies.
If your pretax benefit is tax-exempt, subtract your premium from your gross pay before calculating the respective tax. For example, you earn a weekly salary of $620 and pay $50 toward your pretax health insurance plan. Subtract $50 from $620 to arrive at $570, which is subject to federal income tax, Medicare tax, Social Security tax, and if applicable, state and local income tax. If the benefit was offered on an after-tax basis, the entire $620 would be subject to taxation.
For clarification on whether your benefits are taxable or nontaxable, consult your payroll or human resources department.
- IRS.gov: FAQs for Government Entities Regarding Cafeteria Plans
- PWA Insurance: Cafeteria Plans
- Patriot Software: What Are Taxable Wages?
- Pennsylvania Department of Revenue: IRC Section 125 Cafeteria Plans or Flexible Spending Plans
- Alabama Department of Revenue: Frequently Asked Questions Withholding Tax
Grace Ferguson has been writing professionally since 2009. With 10 years of experience in employee benefits and payroll administration, Ferguson has written extensively on topics relating to employment and finance. A research writer as well, she has been published in The Sage Encyclopedia and Mission Bell Media.