IRC 125 Cafeteria Plans: Pre-Tax Benefits, Limits, and Elections

A Section 125 cafeteria plan is an employer-sponsored arrangement that lets you pay for health insurance, dependent care, and certain other workplace benefits with pre-tax salary, lowering both your income tax and payroll tax bill while cutting the employer’s payroll tax cost too. The name comes from Section 125 of the Internal Revenue Code, which carves out a narrow exception to a strict rule: normally, if your employer offers you a choice between cash and a benefit, the IRS taxes you on the full amount regardless of which you pick. A properly written cafeteria plan is what keeps that rule from applying.¹

How the Pre-Tax Mechanism Works

When you redirect part of your paycheck into a qualified benefit through the plan, that money is excluded from federal income tax, Social Security tax, and Medicare tax.² Your taxable wages on your W-2 drop by that amount, so the tax savings happen automatically through payroll rather than on your return.

The employer also saves. Those redirected dollars escape the employer’s share of FICA and federal unemployment (FUTA) tax, which is why most mid-size and large employers offer at least a basic version of the plan. Even a simple Premium Only Plan, which just lets employees pay their share of health insurance premiums pre-tax, produces meaningful FICA savings across a workforce.

What You Can Pay for Pre-Tax

Not every benefit qualifies. Section 125 limits the menu to benefits that are already excluded from income under another part of the tax code.¹ In practice, the common ones are:

Employer-sponsored medical, dental, and vision insurance premiums.
Health Flexible Spending Accounts (FSAs) that reimburse copays, prescriptions, eyeglasses, and other out-of-pocket medical costs.
Dependent Care Assistance accounts covering child care or elder care expenses necessary for you (and your spouse, if married) to work.
Group-term life insurance, which is tax-free up to $50,000 of coverage; coverage above that threshold produces taxable imputed income.³⁴
Adoption assistance, though with a wrinkle: unlike most cafeteria plan benefits, it still gets hit with Social Security, Medicare, and FUTA tax even while it escapes income tax.²
Health Savings Account contributions, if you’re enrolled in a qualifying High Deductible Health Plan.

What Section 125 Doesn’t Cover

The biggest prohibition is deferred compensation. A cafeteria plan generally can’t include any benefit that lets you receive value in a later year rather than the current one. The limited exceptions are 401(k) contributions and HSA contributions, both of which can flow through the plan.¹

Two other exclusions catch people off guard. Long-term care insurance can’t be offered through a cafeteria plan, even though it looks like it should fit next to health coverage. And individual health plans purchased through an Affordable Care Act marketplace exchange are generally excluded, with a narrow carve-out for qualifying small employers offering group coverage through an exchange.¹ If you buy your own marketplace plan, you cannot run those premiums through your employer’s cafeteria plan.

2026 Contribution Limits

Several of the pre-tax accounts have annual dollar caps that adjust for inflation. For the 2026 plan year:

Health FSA: maximum employee salary reduction of $3,400. If the plan allows a carryover of unused funds, the carryover cap is $680.⁵
Dependent Care FSA: statutory maximum of $7,500 per household, or $3,750 if married filing separately.⁶
Group-term life insurance: the first $50,000 of employer coverage remains tax-free. That threshold is set by statute and does not adjust for inflation.⁴

The limits apply per employee, not per plan. If you’re covered under two cafeteria plans with two different employers, you still can’t exceed the combined cap.

Why Your Election Is Locked In

The core rule for cafeteria plan elections is irrevocability. You pick your benefits before the plan year starts, and those choices stay in place for the full twelve months. You generally cannot drop dental in March or bump up your FSA contribution in July just because you’ve changed your mind.

The exception is a qualifying life event, which the regulations call a “permitted election change.” Common ones include marriage or divorce, the birth or adoption of a child, a change in your spouse’s job or coverage, and gaining or losing eligibility for other health coverage. The new election has to be consistent with the event. Adopting a child, for example, lets you move from individual to family coverage.⁷

Two details matter. First, the plan document itself has to list which events the employer recognizes; employers aren’t required to allow every event listed in the regulations. Second, you have to request the change and provide documentation within a short window after the event. Miss that window and the plan administrator must deny the change to protect the plan’s tax-qualified status.

Use It or Lose It, and What Happens When You Leave

Health FSAs and dependent care FSAs carry a forfeiture rule: money left in the account at the end of the plan year goes back to the employer. This is why conservative elections usually beat aggressive ones.

Employers can soften the health FSA version of this rule in one of two ways, but not both:

A grace period of up to two and a half months after the plan year ends, during which you can still incur expenses against last year’s balance. For a calendar-year plan, that pushes the deadline to March 15.⁸
A carryover of up to $680 of unused funds into the next plan year. Anything above $680 is still forfeited.⁹

A plan cannot offer both the grace period and the carryover for the same FSA.⁹ Dependent care FSAs can use a grace period but are not eligible for the carryover option.

Leaving the job complicates this further. Unused health FSA money is forfeited at separation unless you elect COBRA continuation coverage for the FSA.⁹ COBRA lets you keep spending the account through year-end, but you pay the full contribution plus a 2% administrative fee out of pocket. If you’ve already spent more than you’ve contributed for the year, COBRA usually isn’t worth it, since the employer can’t claw back the excess. Dependent care FSAs are not COBRA-eligible; you typically get a short run-out period to submit claims for expenses incurred while you were still covered, and anything left afterward is forfeited.

What the Employer Has to Do

Written Plan Document

A cafeteria plan has to be a formal written document adopted before the plan takes effect. This isn’t optional, and it can’t be done retroactively. The document must spell out the benefits offered, who is eligible, how and when elections are made, and which qualifying events allow mid-year changes.² Running a cafeteria plan without a written document is a common compliance failure, and the IRS treats the plan as if it never existed.

Nondiscrimination Testing

The IRS does not let cafeteria plans function as a tax shelter for executives while rank-and-file employees get nothing meaningful. Three tests enforce that principle.¹ An eligibility test looks at whether enough non-highly-compensated employees can participate. A contributions and benefits test looks at whether actual use of the plan tilts too heavily toward highly compensated individuals. And a concentration test caps the share of total nontaxable benefits going to key employees at 25%.

When a plan fails, the penalty falls on the highly compensated or key employees, not everyone else. Those individuals lose the pre-tax treatment of their elected benefits and have to include the amounts in gross income for the year. Small employers with a few highly paid owners are the most frequent casualties of the concentration test.

Simple Cafeteria Plans for Small Employers

An employer with 100 or fewer employees can skip the nondiscrimination testing by setting up a “simple cafeteria plan.” If it meets the statutory contribution and eligibility rules, it’s automatically treated as passing every nondiscrimination test that would otherwise apply.¹

The trade-off is a mandatory employer contribution. The employer has to either contribute a uniform 2% of each eligible employee’s compensation, or match at least the lesser of 6% of compensation or twice the employee’s own salary reduction.¹ The match rate for highly compensated and key employees can’t exceed what everyone else gets. All employees with at least 1,000 hours of service in the prior plan year must be eligible.

Payroll Reporting

Salary reductions made through the cafeteria plan are excluded from the wages reported in Boxes 1, 3, and 5 of the employee’s W-2, reflecting their exclusion from income, Social Security, and Medicare tax.² Over-reporting makes the employee pay too much tax; under-reporting can trigger penalties on audit. Getting the payroll setup right at the start is cheaper than fixing it later.

1
Office of the Law Revision Counsel. 26 USC 125 – Cafeteria Plans
2
Internal Revenue Service. FAQs for Government Entities Regarding Cafeteria Plans
3
Internal Revenue Service. Group-Term Life Insurance
4
Office of the Law Revision Counsel. 26 USC 79 – Group-Term Life Insurance Purchased for Employees
5
FSAFEDS. New 2026 Maximum Limit Updates
6
Office of the Law Revision Counsel. 26 USC 129 – Dependent Care Assistance Programs
7
eCFR. 26 CFR 1.125-4 – Permitted Election Changes
8
Internal Revenue Service. Notice 2005-86
9
Internal Revenue Service. Notice 2013-71 – Modification of Use-or-Lose Rule for Health Flexible Spending Arrangements