California Cafeteria Plans
A cafeteria plan is a type of employee benefit plan offered in the United States pursuant to Section 125 of the Internal Revenue Code. Its name comes from the earliest such plans that allowed employees to choose between different types of benefits, similar to the ability of a customer to choose among available items in a cafeteria. Qualified cafeteria plans are excluded from gross income.
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To qualify, a cafeteria plan must allow employees to choose from two or more benefits consisting of cash or qualified benefit plans. The Internal Revenue Code explicitly excludes deferred compensation plans from qualifying as a cafeteria plan subject to a gross income exemption. Section 125 also provides two exceptions.
The big benefit of a cafeteria plan is a reduced tax hit. By funding the plan with pre-tax dollars, it reduces an employee’s taxable income and thus the amount they lose to taxes. (In this respect, it’s similar to a 401(k) or FSA account.) Money directed into the plan is free from federal income tax, as well as Social Security and Medicare (FICA) taxes.
In addition to saving on taxes, these plans offer flexibility. The employee gets to select from a range of offered benefits to pay from the pre-tax account. Workers can use the earnings to pay for benefits they want and need, such as health and life insurance, medical costs and childcare expenses.
An important feature of cafeteria plans is that the employee has to be able to choose not to contribute to the plan. Instead, he or she can elect to receive the money as income. With conventional employer-paid health insurance, an employee who doesn’t use the plan is getting no benefit from it. (This might happen if a spouse already has family coverage through another job.) A cafeteria plan lets such employees turn an unused benefit into cash – though, of course, that part of the worker’s wages or salary would be subject to taxes.
The plans save money for employers as well. That’s because the employer doesn’t have to pay the other half of the FICA tax on salary and wages put in a cafeteria plan. Smaller employers may offer these as a cheaper alternative to company-paid employee health coverage. With a cafeteria plan, employees can get tax-advantaged dollars to pay for their own insurance.