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