Understanding Section 125 Cafeteria Plans

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Overview​

Cafeteria plans are a vehicle for employers to offer certain benefits to employees on a tax-free basis. Cafeteria plans are also referred to as Section 125 plans, after the section of the Internal Revenue Code (IRC) that regulates such arrangements.

A cafeteria plan gives employees a choice between at least one taxable benefit (often cash) and at least one qualified benefit—that is, a benefit whose cost to the employee is excludable from their taxable gross income. The employee's share of the cost is made through pretax payroll deductions. Without a Section 125 plan, employee contributions can only be made with after-tax dollars.

The tax savings for employees through the use of pretax dollars to pay for benefits can be substantial. For example, an employee who spends $200 a month in pretax dollars for benefits can in effect save $60, assuming about 30 percent of the $200 would have gone to federal, state and local income taxes and Federal Insurance Contributions Act (FICA) taxes—the ones deducted for Social Security and Medicare.

The employer also saves on taxes: For each $200 a month that an employee sets aside, the employer saves about $15—the 7.65 percent of the employee's wages that the employer would otherwise pay in FICA taxes. However, the employer's tax savings may be largely offset by the costs of implementing and maintaining a pretax cafeteria plan.

Any employer with employees who are subject to U.S. income taxes is eligible to sponsor a cafeteria plan. Employers can be C corporations, S corporations, LLCs, partnerships, governmental entities or sole proprietorships. However, nonemployees cannot participate in a cafeteria plan; this exclusion applies to partners in a partnership, members of an LLC and individuals who own more than 2 percent of an S corporation.

Because of the tax-favored treatment when sponsoring a cafeteria plan for employees, there are significant rules employers must comply with. 

The three main requirements for establishing a cafeteria plan are:
	​Creating a written plan document that outlines the adminstration of the plan.
​	Limiting employee election changes to only those allowed by law.
​	​Complying with nondiscrimination requirements that prohibit the plan from favoring highly compensated or key employees.

Types of Cafeteria Plans

Required Documentation

Several required documents are designed to ensure that a cafeteria plan is compliant with laws and regulations. Such documents include a main plan document and an adoption agreement (sometimes combined into one document) that detail the legal and employer-specific aspects of the employer's benefits plan, including the benefits that are offered, who is eligible to participate, the manner of contributions and other legal notices.

Most employee benefit plans are covered by the Employee Retirement Income Security Act (ERISA) and must also furnish a summary plan description (SPD). An SPD is a plain-English version of the main plan document and the adoption agreement, and it is meant to inform employees about the aspects of the cafeteria plan. The SPD must be provided to all eligible employees. The plan documents must be updated and amended at least every five years to reflect any applicable plan changes or regulatory updates.

An insurance policy, coverage certificate or plan booklet received from the insurance carrier or third-party administrator (TPA) will generally not satisfy the SPD or plan document requirement. While these documents often include detailed descriptions of the benefits available under the plan, they rarely include all required information, such as a named fiduciary or the procedures for amending the plan.

One simple and cost-effective solution is the wrap document, a relatively simple document that "wraps around," or incorporates, the insurance policy, coverage certificate or plan booklet. The benefits available under the plan continue to be governed by the insurance policy, coverage certificate or plan booklet, while the wrap document supplements it with the information necessary to comply with ERISA. In effect, the wrap document fills the gaps left by insurance carriers and TPAs. See What is the difference between a plan document and a summary plan description?

Employers must ensure that the rules outlined in the plan document and SPD are followed. Failure to administer a plan in accordance with the written terms of the plan and the IRC can result in the loss of the benefits' pretax status.

Employers that utilize a TPA must maintain written medical privacy policies and procedures as required under the Health Insurance Portability and Accountability Act (HIPAA) and have a signed business associate agreement with the TPA. Medical privacy policies and procedures detail how and when an employer can use and disclose protected health information, and the business associate agreement details how and when the TPA can use or disclose protected health information.

The TPA should be able to provide the necessary documentation for the plan documents, the medical privacy policies and procedures, and the business associate agreement. See Summary of the HIPAA Privacy Rule and Business Associate Contracts.

Election Changes

Elections for pretax group health insurance are generally irrevocable for the plan year under Section 125 of the IRC. However, the IRS provides the following specific instances when an employee can make midyear election changes:

​	Change in marital status.
​	Change in number of dependents.
​	​Change in employment.
	Change in dependent eligibility due to plan requirements (e.g., loss of student status, age limit reached).
	Change in residence.
	​Significant cost changes in coverage.
	​Significant curtailment of coverage.
	Addition or improvement to benefits package option.
​	Change in coverage of spouse or dependent under another employer plan (e.g., spouse's employer had no insurance coverage before but now offers a plan).
	Loss of certain other health coverage (e.g., plans provided by governmental or educational institutions).
	HIPAA special enrollment rights.
	Judgments, decrees or orders.
	Entitlement to Medicare or Medicaid.
​	During Family Medical and Leave Act leave.
	Change in hours worked to less than 30 hours per week on average if the employee and covered family members enroll in another plan providing minimum essential coverage.
	Enrollment in a marketplace exchange plan during an exchange special or open enrollment period.

Employers do not have to allow employees to make midyear election changes except those under the HIPAA special enrollment rights. An employer should include in the plan documents and summary plan description information about which events, if any, would allow for an employee to make midyear election changes.

If a change in status does occur, the election changes should be consistent with that event. For example, if an employee divorces, the employee may drop coverage for the spouse but not for themselves or other covered dependents.

With the exception of HIPAA special enrollment events, the amount of time an employee has to request a change to their group health coverage is defined by the employer's plan rules, often 30 or 60 days, and may not be too far removed to ensure the change is clearly consistent with the event.

Nondiscrimination Rules

Section 125 of the IRC prohibits employers from favoring highly compensated individuals and key employees when it comes to eligibility, benefits and utilization under the plan. Annual nondiscrimination tests are required to ensure compliance unless a safe harbor exemption applies.

A highly compensated individual is defined by Section 125 as an individual who is:

• An officer.
• A shareholder owning more than 5 percent of the voting power or value of all classes of employer stock.
• Highly compensated (threshold adjusted annually).
• A spouse or dependent of the above.

A highly compensated participant for the purposes of nondiscrimination testing is a highly compensated individual as defined above who is eligible to participate in the employer's plan.

A key employee is an employee who, at any time during the plan year, is an officer of the company with annual compensation greater than an annually adjusted amount specified by the IRS, as well as either of the following:

• A 5 percent owner of the company.
• A 1 percent owner of the company with annual compensation greater than an annually adjusted amount specified by the IRS.
  

The following three tests are required to satisfy the Section 125 nondiscrimination requirements:

• Eligibility test. The plan must not discriminate in favor of highly compensated individuals regarding eligibility to participate in the plan.
• Benefits and contributions test. The plan must ensure that highly compensated participants do not select more nontaxable benefits than non-highly compensated participants.
• Key employee concentration test. The plan must not allow key employees to receive nontaxable benefits in excess of 25 percent of the total nontaxable benefits provided to all employees under the plan.
  

If a cafeteria plan fails any of the nondiscrimination tests, then the highly compensated participants and/or key employees will lose the tax-free status provided by the cafeteria plan.

Safe harbors for simple cafeteria plans and premium-only plans are available. If a premium-only plan satisfies the eligibility test for a particular plan year, the plan is treated as meeting the nondiscrimination rules of Section 125 for that plan year.

Employers with 100 or fewer employees during either of the two preceding plan years are eligible to establish a simple cafeteria plan. Simple cafeteria plans are treated as meeting the nondiscrimination requirements of Section 125 if certain contribution and eligibility requirements are met.

• Eligibility and participation requirements. Employers must allow employees with at least 1,000 hours of service in the preceding plan year to participate in the plan and elect any benefit available under the plan, with limited exception.
• Contribution requirements. Employers must make benefit contributions for each qualified employee—one who is not a key employee or highly compensated—in an amount equal to one of the following:
  • A uniform percentage (not less than 2 percent) of the employee’s compensation for the plan year.
    
  • The lesser of at least 6 percent of the employee’s compensation for the plan year or twice the employee’s salary reductions. If this option is used, the rate of contribution to a highly compensated or key employee’s salary reduction cannot be greater than the rate of contribution to any other employee.

See IRS Publication 15-B for more information on simple cafeteria plans.

Nondiscrimination rules and requirements are complex and can vary depending on the type of pretax benefit being offered. Employers offering a cafeteria plan should seek the advice of a benefits attorney or TPA experienced in nondiscrimination testing. More details on the Section 125 nondiscrimination rules can be found in the 2007 proposed cafeteria plan regulations, which, while not finalized, were effective as of Jan. 1, 2009.