20 Advantages and Disadvantages of a Cafeteria Plan (Section 125 Plan)

Cafeteria plans, also called Section 125 plans, are growing in popularity. Their introduction came during the early 1980s when flexible benefits became a priority for workers. Employers used them to provide multiple benefits, including healthcare insurance, in a package that offered tax savings advantages for the business and its employees.

Two cafeteria plans get implemented more often than any others. Most employees use flexible spending arrangements (FSAs) or pre-tax premium conversion plans. It is not unusual to combine the features of both selections into the design implemented at the company. There’s also the option to have a full-flex plan that offers the original Section 125 concept of having multiple insurance providers, coverages, cash, or vacation days.

The IRS outlines the legal requirements for these plans under Section 125 of the Internal Revenue Code. When reviewing the advantages and disadvantages of a cafeteria plan, it is essential to remember that it cannot discriminate in eligibility, contributions, or benefits.

List of the Advantages of a Cafeteria Plan

1. This approach addresses the needs of employees.
Workers get to choose the specific benefits that meet their unique needs when using the cafeteria plan approach. Instead of getting locked into a place where you must accept the same benefits each year, employees have an opportunity to adjust their selections annually when their needs change.

Most options also allow workers to make changes when there is a significant life event, such as a marriage, divorce, or the birth of a child. That allows a business to provide better supports for its workers without discrimination while each employee receives a somewhat customized approach.

2. It requires businesses and workers to pay less tax.
When using the cafeteria plan, employers will not pay the FUTA or FICA taxes on the salary reduction amount for each paycheck. Workers aren’t paying the federal income tax, FICA, or state and local income taxes on the reduction amounts in most jurisdictions. It usually creates a scenario where employees come home with more money available on their paycheck even with the benefits being distributed to them.

3. Cafeteria plans offer a measure of cost control.
Cafeteria plans help businesses begin to control costs because they ensure that the funds are not spent on unwanted or unneeded benefits. That means the exact expense each year can redistribute wasted resources to other company needs. Although the savings won’t be much for a small business or startup, large companies can save hundreds of thousands of dollars each year with this advantage – and often much more than that.

4. It creates a competitive benefits program.
When companies offer a cafeteria plan to their workers, then it creates more competition within the benefits field. That means workers can gain access to more choices and lower prices because innovation and value become the drivers toward success. This advantage also lets a business get a competitive edge in the recruiting process. The best workers have an attraction to better benefits, so that means it costs less to maintain the employment base.

5. Improvements occur within the employee-employer relationship.
When employees have control over their benefits, then a company works toward higher levels of goodwill within the workforce. Instead of treating people as a commodity, the cafeteria plan approach works to build partnerships within each team so that each entity receives the maximum level of available benefits each year. It communicates to workers that they are valuable beyond their productivity levels, creating more employee loyalty so that lower churn and turnover rates occur in time.

6. Workers have a better understanding of their benefits.
Employees have a better understanding of their benefits package each year because they’re in charge of making selections for it. Although someone could pick-and-choose items without doing any research, most workers take a deliberate approach to this process. Each person works out a plan that offers them the most value for what they provide to an organization every day.

Because there is such a high level of active ownership of the benefits received, employees have more ownership over their performance each day. Businesses see higher productivity levels when using the cafeteria plan approach to the issuance of benefits.

7. It can respond to the needs of a diverse workforce.
The cafeteria plan approach can address the wide variety of needs that employees have when coming from diverse environments. Instead of forcing everyone into cookie-cutter scenarios that might not address their unique requirements, employers can take the benefits a Section 125 offer provides to create more individualization at a variety of levels. Since a written plan document is necessary to provide the approach meets the specified requirements of the benefits, workers have guarantees in writing for the entire year for what they’ll receive with regard to compensation in this area.

8. This approach can soften the blow that rising premiums can cause.
Every dollar that workers run through a Section 125 plan reduces their employer’s payroll. Not paying workers’ comp premiums or FICA can result in savings that add up to as much as 20% of each dollar passed through the plan. This advantage allows for premium increases to have less of a detrimental effect on workers. If a company’s medical premiums go up by 10% year-over-year, then a $1,000 cost goes to $1,100. When you use this advantage, workers in the 25% tax bracket would see even more savings from the cost.

9. The tax savings can get used to invest in retirement plans.
When workers have an opportunity to use a flexible savings account, then there are opportunities to save money on everyday expenses. That means more cash gets freed up to be allocated to other needs, including a 401(k) or 403(b) account. Most companies find that the offering of a cafeteria plan increases the participation rates in the retirement benefits being provided.

Even if money doesn’t go toward a retirement plan, employees can have more discretionary spending funds to use for a variety of needs. It is easier to establish an emergency savings plan with the freed-up cash from a cafeteria plan than it is to use a more traditional benefits package.

10. Cafeteria plans follow comprehensive non-discrimination rules.
Cafeteria plans are subject to the nondiscrimination rules of the IRS under Section 125. That means each plan must meet an eligibility test that provides it doesn’t discriminate against employees with high wages. It must provide consistent benefits and contributions to each employment level, and the non-taxable benefits to key workers cannot exceed 25% of those provided to all employees under the plan.

If a plan fails any of the above tests, then the organization will lose the favorable tax treatment of this benefit. Participants who are not key workers or highly compensation will not lose their tax benefits even in this scenario because they’re not impacted by the failure of a plan to pass this testing.

11. It provides a larger dependent care deduction.
Using a cafeteria plan can provide a greater deduction for dependent care expenses than some workers would receive with their tax filing each year. Although recent changes to the tax code have modified this advantage somewhat, parents with multiple children in daycare or other qualifying caregiving situations will want to compare tax credit availability with their benefits to see what method helps them the most.

Even though the costs are comparable, using pre-tax funds to pay for these expenses reduces the impact of your financial obligation to the government. A $5,000 qualifying benefit for someone paying 12% in taxes would offer more than $500 in value for the entire year.

List of the Disadvantages of a Cafeteria Plan

1. Businesses can only offer a cafeteria plan to employees.
Every participant in a cafeteria plan must meet the definition of an employee. That means full-time independent contractors, freelancers, gig workers, and other essential staff may get excluded from this benefits package. If there isn’t another form of compensation offered to these people, then it is possible that the company could lose their talent because those who are employees will receive a better benefits package.

2. Some of the benefits are only available for a limited time.
The workers who decide to participate in a Section 125 plan may need to put funds into it as a way to manage their benefit needs. Structures within this concept have a limited time to use the money that’s set aside. If a worker is using an FSA to help them with unexpected healthcare costs, then any funds put into that plan will go away if they remain unused at the end of the year. That’s why many workers are looking at health savings accounts or alternative methods of pre-tax savings to make their money stretch further.

3. It may require workers to pay out-of-pocket expenses.
When there is an employee fund being used as part of a cafeteria plan, then most workers will need to pay for their care expenses upfront. Most health flexible spending accounts use this approach as a way to ensure that the services provided meet the distribution qualifications set forth by the plan. That means workers must pay for the services that they need first. Then they will ask for a reimbursement by making a claim through the plan.

Although the costs are generally covered by this benefit, some cafeteria plans may have strict guidelines on some procedures that some workers may not know. Before receiving an MRI, it may be necessary to receive prior approval. Failing to follow the rules may result in the entire expense being fronted by the worker without receiving compensation.

4. There can be initial setup fees that must get paid.
An initial setup fee is necessary for most businesses that want to offer a cafeteria plan to its workers. Even though the expense gets offset by the cost savings that occur in time, the initial cost may be more than some small businesses can manage. That’s why many companies will need to speak with their tax accountant or legal representation to determine what the potential impacts of a Section 125 plan could be on their current structure.

5. Most employees cannot change their cafeteria plan for an entire year.
The elections made by workers with a cafeteria plan are usually irrevocable until the beginning of the next plan year. Most will usually permit employees to revoke elections or make a new one in the middle of the year when qualifying circumstances apply. FMLA leave, Medicare entitlements, special enrollment, significant coverage changes, and change-in-status events are typically the only reasons why changes are permitted.

Even when a qualifying event occurs, the cafeteria plan only allows workers to make election changes that are consistent with what happened in life. If a worker gets divorced, then they can remove their spouse or domestic partner while adding children. Canceling their health coverage would not be permissible.

6. Ongoing compliance issues can add unwanted complexity to the cafeteria plan.
The laws regarding cafeteria plans are constantly updated and changing. Federal legislation in the U.S. requires that Section 125 plans cannot discriminate on benefits or eligibility now, but there can also be new updates that occur at almost any time to manage. Even though some companies can start saving money in the first month they offer this option with a premium-only plan, the infrastructure needed to enforce the new benefits plan can create circumstances that become costly if the agency falls out of regulatory compliance.

7. Businesses must distribute a summary plan description to everyone.
Although workers would see this issue as an advantage, the time and labor needed to distribute a summary plan description to every participant can be significant. Section 104(b) of the Employee Retirement Income Securities Act of 1974 requires summary documentation to go to every worker within 90 days of becoming a participant. If the cafeteria plan recently became subject to the law’s requirements, then an agency has 120 days to send out this paperwork.

Participant beneficiaries must also receive this documentation within 90 days of becoming eligible for benefits. Companies must also file the paperwork with the Department of Labor within 120 days of the plan’s effective date.

8. It may require more financial liquidity for some businesses.
Employers set a limit on the number of benefits they’re willing to reimburse. Workers can choose to purchase more benefits than they receive from their company, using a portion of their pre-tax dollars to do so. When employees decide to forgo their benefits or take less than the maximum amount a company pays, then a cafeteria plan allows that worker to take a cash benefit instead.

That means employees can choose healthcare benefits, vacation days, and other selections or decide to receive a direct cash contribution. If several workers choose the latter option, then agencies may need to keep more financial liquidity available each period to ensure they can meet their obligations. In this circumstance, they might also be paying more for some benefits than necessary.

9. It can cost more for some companies.
When companies use the traditional approach to benefits, workers who decide to avoid certain selections forfeit their rights to them. If you already receive healthcare coverage from a spouse, then the employee would not receive any compensation with the benefit denial. The cafeteria plan turns that into a potential cash benefit. That means a health plan valued at $12,000 in benefits could come in cash or some other combination – but employees will need to pay taxes on whatever cash payments they decide to receive.

Conclusion

If your business is weighing the advantages and disadvantages of cafeteria plans, then the first stop on that journey should be to review the Employer’s Guide to Fringe Benefits section on the subject in the IRS Employer’s Guide. This information will help you to understand the different benefit types that fall into this category.

Most companies find that the use of a third-party administrator is the simplest route to use when setting up a Section 125 plan. The outsourced agency can handle the daily administration requirements while the internal human resources team can help workers understand the benefits of each offer.

Clear lines of communication are necessary to avoid the disadvantages of using this approach. Cafeteria plans may not be for everyone, but it can be an easy way to attract and retain the best talent in a community.