Cafeteria Plan (Section 125) Tax Savings Calculator

A Cafeteria Plan (Section 125 Plan) is an employee benefit program that allows workers to pay for certain expenses with pre-tax dollars, reducing their taxable income and increasing take-home pay. These plans are named “cafeteria plans” because employees can choose from a menu of benefits, similar to selecting items in a cafeteria.

1. What is a Cafeteria Plan (Section 125)?

A Cafeteria Plan, governed by IRS Section 125, is an employer-sponsored benefit program that lets employees pay for qualified expenses using pre-tax income. This means the money is deducted from their paycheck before taxes are applied, lowering their taxable income and increasing net pay.

Key Features:

✅ Pre-tax deductions reduce federal, state, and FICA taxes.
✅ Employees can choose from multiple benefit options.
✅ Employers also save on payroll taxes.

Common examples of Cafeteria Plans include:

• Health Flexible Spending Accounts (FSAs)
• Dependent Care FSAs
• Premium-only plans (POPs) for insurance premiums

2. Types of Benefits Under a Cafeteria Plan

Employees can allocate pre-tax dollars to various benefits, including:

A. Health Flexible Spending Account (FSA)

• Covers medical, dental, and vision expenses not paid by insurance.
• 2024 Contribution Limit: $3,200 per year (individual).
• “Use it or lose it” rule – funds expire at year-end (some plans offer a grace period or carryover).

B. Dependent Care FSA

• Pays for childcare or elder care expenses so employees can work.
• 2024 Contribution Limit: $5,000 per household ($2,500 if married filing separately).

C. Premium-Only Plan (POP)

• Allows employees to pay health insurance premiums pre-tax.
• No annual contribution limits.

D. Adoption Assistance FSA

• Helps cover adoption-related costs.
• 2024 Limit: $16,810 per child (tax-free).

E. Commuter Benefits

• Pre-tax deductions for parking, transit, and rideshare costs.
• 2024 Limits:
  • Transit: $315/month
  • Parking: $315/month

3. How Cafeteria Plans Reduce Taxes

The primary advantage of a Section 125 Plan is tax savings. Here’s how it works:

A. Lower Taxable Income

• Pre-tax deductions reduce federal income tax, state income tax, and FICA taxes (Social Security & Medicare).
• Example: If an employee earns $50,000 and contributes $3,000 to an FSA, their taxable income drops to $47,000.

B. Employer Payroll Tax Savings

• Employers also save 7.65% (FICA taxes) on employee contributions.

C. Example Calculation

Scenario	Without FSA	With FSA ($3,000 Contribution)
Gross Income	$50,000	$50,000
Pre-Tax Deduction	$0	$3,000
Taxable Income	$50,000	$47,000
Estimated Tax Savings (24% bracket + FICA)	$0	$1,380+

4. Eligibility and Participation Rules

• Employees: Must opt in during open enrollment or a qualifying life event.
• Employers: Must follow IRS nondiscrimination rules (cannot favor highly compensated employees).
• IRS Limits: Annual contribution caps apply (e.g., $3,200 for Health FSA in 2024).

5. Common Cafeteria Plan Expenses

Here’s what you can pay for with pre-tax dollars:

✅ Medical FSA: Doctor visits, prescriptions, glasses, dental work.
✅ Dependent Care FSA: Daycare, after-school programs, elder care.
✅ Commuter Benefits: Bus passes, parking fees, vanpool costs.

❌ Non-Qualified Expenses: Health club memberships, cosmetic procedures, vitamins (without a prescription).

6. Pros and Cons of a Section 125 Plan

Pros:

✔ Lower taxes (federal, state, and FICA).
✔ Higher take-home pay due to reduced taxable income.
✔ Employer savings on payroll taxes.

Cons:

✖ “Use it or lose it” rule for FSAs (some exceptions apply).
✖ Limited flexibility – changes only during open enrollment or qualifying events.

Conclusion

A Section 125 Cafeteria Plan is a powerful tool to reduce taxable income and increase take-home pay. By contributing to an FSA, Dependent Care FSA, or commuter benefits, employees and employers both save on taxes.

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