What is a Section 125 cafeteria plan?
The one idea that explains everything
Normally, your paycheck gets taxed first and you buy things second. A cafeteria plan flips the order for specific benefits: the money comes out before federal income tax, Social Security, and Medicare are calculated. You're buying the same benefits with dollars that were never taxed — which is why that “Cafe 125” line on your W-2 makes your taxable wages smaller.
What can go on the menu
- Your share of health, dental, and vision premiums. The simplest version of a cafeteria plan — called a Premium Only Plan, or POP — does just this.
- Health FSA — set aside pre-tax money for medical expenses. For 2026, the IRS limit is $3,400.
- Dependent care FSA — pre-tax money for childcare so you can work. For 2026, up to $7,500 per household — the first increase to that limit since 1986.
- Certain other benefits, like group-term life up to $50,000.
Notably not on the menu: individual health policies you buy on your own (in most setups), gym memberships, and anything the IRS considers a personal expense.
Who saves, and how
Employees skip federal income tax and payroll taxes on what they run through the plan. Employers skip their matching share of Social Security and Medicare on those same dollars — which is why offering one can genuinely be a two-sided win rather than a perk with a hidden cost. How much anyone saves depends on wages, tax brackets, and participation, so treat any specific savings number you see in an ad with suspicion.
The rules that surprise people
- It must exist in writing. A cafeteria plan is a legal document your employer adopts — payroll just deducting things pre-tax without one isn't compliant.
- Elections lock for the year. You choose during open enrollment, and you're committed unless you have a qualifying life event — marriage, a baby, a job change in the household.
- Owners mostly can't play. Sole proprietors, partners, and most S-corp owners (2% or more) generally can't participate themselves, even though their employees can.
- Fairness is tested. Plans have to pass nondiscrimination tests so they don't only benefit the highly paid.
Thinking about one for your business?
The plan document is the whole game. We walk you through what it is, what it costs, and whether it's worth it for your headcount — in plain English, no schemes.
See how Section 125 setup works