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Understanding Section 125: the Cafeteria Plan

Updated: Apr 20, 2023

Disclaimer: Informational statements regarding insurance coverage are for general description purposes only. These statements do not amend, modify or supplement any insurance policy. This website does not make any representations that coverage does or does not exist for any particular claim or loss, or type of claim or loss, under any policy. Whether coverage exists or does not exist for any particular claim or loss under any policy depends on the facts and circumstances involved in the claim or loss and all applicable policy wording.

Commonly referred to as a cafeteria plan, a Section 125 benefits plan offers employees a choice between non-taxable benefits or non-taxable and taxable benefits. Under Section 125 of the Internal Revenue Code, adding a taxable option to a cafeteria plan does not make the other options taxable, and the taxable benefit can be cash.

Who benefits from a cafeteria plan?

A cafeteria plan is designed to offer employees a choice of pre-tax benefits. To be eligible for a cafeteria plan, participants must be employees of a corporation, LLC, government entity, partnership, or a sole proprietor. Partners, members or owners of more than 2% of the business are not eligible.

The primary benefit to both employees and employers from a Section 125 plan is financial. Both employers and employees use pre-tax dollars to pay for benefits. On the employee side, that can amount to a 30% savings. For employers, the savings is smaller and can be offset by the costs of offering and maintaining the plan.

Types of Cafeteria Plans

The hallmark of a cafeteria plan is providing options so employees can choose the coverage that is right for them. There are four different types of cafeteria plans you could offer your employees:

  • Simple - employers with fewer than 100 employees contribute to each eligible employee’s benefits and enjoy protection from certain requirements

  • Flex spending - employees establish savings accounts with pre-tax contributions for healthcare and childcare expense

  • Full flex - employers pay toward benefits for all employees, and employees are able to make pre-tax contributions to any plan benefits not fully covered

  • Premium only plan - employees can choose their full salary in cash or contribute a pre-tax portion of it to the benefits they elect

A cafeteria plan could include coverage for dependent care, adoption assistance, health and wellness and accidental death, giving you a lot of variables to manage in developing the right plan for your company.

Open Enrollment

Employees may elect cafeteria plan options or change their elections only at the beginning of the plan year, during the open enrollment period. Generally, the only exceptions to the open enrollment rule are:

  • Change-in-status events

  • Significant coverage or cost changes

  • Special enrollment entitlements

  • Family and Medical Leave Act (FMLA) leave

  • Medicare entitlements

A change-in-status event would be a something like a marriage or divorce that changes an employee’s employment status or the status of one or more dependents.

One example of a change-in-status event triggering a change in benefits election midyear would be employment termination. If a former employee chooses to elect COBRA benefits, his costs will increase significantly. That employee would be allowed to change his plan election, if it were consistent with his change in status, to a less expensive plan.

Non-Discrimination Rules

Discrimination in health insurance plans is measured by the consistency of plans offered to highly-compensated employees, key employees, and everyone else.The cafeteria plan you offer your employees must pass three non-discrimination tests.

  • It cannot be discriminatory in eligibility to participate.

  • It may not discriminate in the benefits and contributions afforded to employees.

  • It may not offer highly-compensated employees benefits that exceed 25% of the benefits offered all employees.

The failure of your cafeteria plan to pass non-discrimination rules will cost key and highly-compensated employees participating in the plan their favorable tax treatment but not effect other employees.

Still Have Questions? We Have Answers!

The complexities of a Section 125 insurance plan can be compounded by the size and structure of your company. To learn more about how to effectively design a cafeteria plan that benefits both employer and employees, contact Northern Insuring.



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