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Cafeteria Plans Grow in Popularity

Since their introduction in the early 1980's, cafeteria plans (also called "flexible benefits plans" or "Section 125 plans") have become a popular method for employers to provide health and other benefits in a way that results in employee choice as well as tax savings for both the company and its workers.

Types of Cafeteria Plans

The two most popular types of cafeteria plans are pre-tax premium conversion plans and flexible spending arrangements (FSA's). Many employers combine both in their plan design. A third type, the "full-flex plan," offers true cafeteria-style choices that may include multiple health plan options, different levels of life and disability insurance coverages, vacation days or cash. Because the full flex plan is administratively complex and generally used only by larger companies, it is not discussed here.

Premium Conversion

Premium conversion, the simplest type of cafeteria plan, permits employees to pay their share of premiums for health coverage, life insurance and other qualified benefits such as disability insurance on a pre-tax basis. The plan "converts" what would otherwise be after-tax employee contributions to pre-tax contributions by means of an employee's election, prior to the beginning of the year, to reduce pay and to have the company contribute the amount of the reduction to pay for the coverage selected by the employee.

Flexible Spending Arrangements

Flexible spending arrangements (FSA's) are also popular. FSA's enable employees to set aside money on a pre-tax basis to pay medical and dependent care expenses. Prior to the beginning of the plan year, employees decide whether and how much to contribute to an available FSA based on the expenses they anticipate during the upcoming year.

There are two types of FSA's -- health and dependent care.

Health FSA

Employees may set aside money in a health FSA to pay health plan deductibles and co-payments as well as other uninsured medical care expenses, such as dental or vision expenses, on a pre-tax basis.

Under IRS rules, the full amount elected for the plan year must be available to reimburse the employee's medical expenses at all times during the year (less any amount already reimbursed). This is the "uniform reimbursement" rule. In addition, the elected amount cannot be changed during the plan year unless the employee experiences a "change in status" (such as the birth or death of a dependent, marriage, divorce, etc.) and the plan permits the change. Finally, unused funds remaining in an employee's account at the end of the plan year may not be refunded to the employee or carried over to the next year. This is the "use it or lose it" rule.

Dependent Care FSA

Employees may be reimbursed under this FSA for dependent care expenses that enable the employee (and spouse) to work. Dependent care FSA's are not subject to the uniform reimbursement requirement. However, they are subject to the "use it or lose it" and "change in status" rules.

Legal Requirements

Section 125 of the Internal Revenue Code contains the legal requirements for a cafeteria plan. There must be a written plan document meeting specified requirements and all participants must be employees. For employees to obtain maximum tax advantages, the plan must not discriminate in favor of highly compensated persons as to eligibility to participate, employer contributions or benefits. In addition, each cafeteria plan must file an annual informational report (Form 5500) with the IRS.

Pros and Cons of a Cafeteria Plan

  1. Pay Less Tax. Employers do not pay FICA or FUTA taxes on salary reductions amounts. Employees do not pay federal income tax, FICA tax, and, in Michigan and most other states, state and local income taxes on their salary reduction amounts.
  2. Address Employee Needs. Employees can choose benefits that meet their individual needs and adjust those choices annually as needs change.
  3. Cost Control. Cafeteria plans help employers control costs by ensuring that money is not spent on benefits that employees neither want nor need.
  4. Competitive Benefit Program. By offering more flexible cafeteria-type benefits, employers gain an edge in attracting and retaining valuable employees.
  5. Improve Employee-Employer Relationship. Giving employees control over their benefits promotes goodwill and creates a partnership in the benefit program between employer and employee.
  6. Respond to Work-Force Diversity. Cafeteria plans address the wide variation in benefit needs of diverse employees.
  7. Better Understanding of Benefits. A better understanding of the benefits package results when employees are actively involved in the selection process.

While cafeteria plans are advantageous to both employers and employees, some drawbacks exist. The uniform reimbursement rule can put the employer at risk if an employee in a health FSA quits before contributing the full amount for which she has been reimbursed, and, under the "use it or lose it" rule, an employee must forfeit unused FSA contributions. However, with proper planning and good communication, the effect of any disadvantages can be greatly minimized.


The advantages of establishing a cafeteria plan are many for both employer and employee and significantly outweigh any perceived disadvantages. Employees can receive the benefits they want while at the same time lowering their and their employer's tax liability and helping to control benefit costs.

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