A Section 125 cafeteria plan is an IRS-sanctioned arrangement that lets you pay for specific employee benefits with pre-tax dollars, lowering your federal income tax and, in most cases, your Social Security and Medicare taxes on the same money. Health insurance premiums, health flexible spending accounts, dependent care accounts, and a short list of other qualified benefits can be routed through the plan. The name comes from the idea that you pick from a menu of benefits during open enrollment, and whatever you elect comes out of your paycheck before taxes are calculated.
How the Pre-Tax Math Works
When you elect a benefit through a cafeteria plan, your employer reduces your gross pay by that amount before withholding is calculated. The IRS doesn’t count that redirected money as taxable wages, so it never shows up on your federal income tax bill. Salary reductions through a Section 125 plan are also generally excluded from Social Security and Medicare taxes (FICA) and federal unemployment tax (FUTA).1Internal Revenue Service. FAQs for Government Entities Regarding Cafeteria Plans
The savings add up quickly. Say you earn $60,000 and contribute $3,000 to a health FSA. Your federally taxable wages drop to $57,000. In a 22% bracket, that alone saves $660 in federal income tax. Skip the 7.65% FICA on the same $3,000 and total savings reach roughly $890. Most states with an income tax also exclude cafeteria plan contributions, which pushes the number higher.
Benefits You Can Pay For Pre-Tax
Not every workplace benefit qualifies. The tax code limits pre-tax treatment to a specific list.2Office of the Law Revision Counsel. 26 USC 125 – Cafeteria Plans The common options are:
- Health insurance premiums for medical, dental, and vision coverage. This is the largest category and the reason most employees encounter a cafeteria plan at all.
- Health FSAs, for out-of-pocket costs like copays, prescriptions, eyeglasses, and dental work.
- Dependent Care FSAs, for childcare, preschool, day camp, or elder care expenses that let you or your spouse work.
- Health Savings Accounts, available only when paired with a qualifying high-deductible health plan. Unlike FSAs, HSA balances roll over indefinitely.
- Group term life insurance up to $50,000 in coverage. Amounts above that stay subject to FICA.1Internal Revenue Service. FAQs for Government Entities Regarding Cafeteria Plans
- Adoption assistance, though these contributions remain subject to FICA and FUTA.
Long-term care insurance is a common surprise on the excluded side: despite being a health-related product, it can’t run through a Section 125 plan.
2026 Contribution Limits
Most cafeteria plan dollar limits adjust for inflation each year. For plan years beginning in 2026:
- Health FSA: up to $3,400 in employee salary reductions.3FSAFEDS. New 2026 Maximum Limit Updates
- Health FSA carryover: up to $680 of unused funds can roll into the next plan year if the plan permits it.3FSAFEDS. New 2026 Maximum Limit Updates
- Dependent Care FSA: up to $7,500 per household, or $3,750 for married filing separately.3FSAFEDS. New 2026 Maximum Limit Updates
- HSA: $4,400 for self-only coverage, set under a separate code section that coordinates with cafeteria plan elections.4Internal Revenue Service. IRS Notice 26-05 – 2026 HSA Limits
These caps apply to your salary reductions only. Employer contributions to HSAs or FSAs follow separate rules and may sit on top of the employee limit in some plan designs. Check both your plan document and the current IRS numbers before open enrollment each fall.
Who Can Participate
Cafeteria plans are open only to common-law employees. Self-employed individuals and partners in a partnership are excluded. So is anyone who owns more than 2% of an S-corporation: the tax code treats their benefit elections as taxable compensation rather than pre-tax deductions.2Office of the Law Revision Counsel. 26 USC 125 – Cafeteria Plans
Within those federal rules, employers set their own eligibility conditions. Waiting periods of 30 to 90 days are common, along with a minimum hours-per-week threshold. Federal nondiscrimination rules keep those conditions from tilting the plan too far toward executives and higher-paid staff.
Use-It-or-Lose-It: The Big Trap
You choose your elections during open enrollment for the upcoming plan year. Once the plan year starts, those elections are locked for twelve months, and money you set aside in a health FSA or dependent care FSA but don’t spend is forfeited. This is the single biggest complaint about cafeteria plans and the rule that catches the most people off guard.
Employers can adopt one of two softening options, but not both:5Internal Revenue Service. Notice 2020-33 – Modification of Permissive Carryover Rule for Health FSAs
- Carryover of up to $680 in unused health FSA funds into the next plan year.
- A grace period of up to two and a half months after the plan year ends during which you can still spend down the remaining balance on eligible expenses.
Because of the forfeiture rule, accurate planning matters. Add up predictable annual costs (prescription copays, planned dental work, regular therapy visits) and contribute close to that number rather than guessing. Overestimating by even a few hundred dollars is real money gone.
Leaving a Job Mid-Year
Unused health FSA money is forfeited when your employment ends, unless you elect COBRA continuation coverage for the FSA itself.6Internal Revenue Service. Notice 2013-71 – Modification of Use-or-Lose Rule for Health FSAs FSA COBRA only runs through the end of the current plan year and you’d pay the full contribution plus a 2% administrative fee out of pocket, so it usually only makes sense with a large balance and known upcoming expenses.
One quirk works in your favor. If you’ve contributed $1,000 so far this year but have already been reimbursed $2,500 in eligible expenses, the employer absorbs the difference when you leave. You don’t have to pay it back.
Dependent care FSAs behave differently. You can only be reimbursed up to what’s currently in the account, so there’s no way to spend ahead of your contributions the way you can with a health FSA. After termination, you can typically still submit claims for dependent care expenses incurred during your employment, up to the remaining balance.
Changing Your Elections Mid-Year
Because elections lock for the year, the IRS spells out a narrow list of qualifying events that let you change them. Any change has to relate directly to the event: a new baby isn’t a reason to drop your own dental coverage.7Internal Revenue Service. 26 CFR Part 1 – Tax Treatment of Cafeteria Plans – Section: Changes in Status
- Change in marital status: marriage, divorce, legal separation, annulment, or death of a spouse.
- Change in number of dependents: birth, adoption, placement for adoption, or death of a dependent.
- Change in employment status: you or your spouse start or end a job, switch between full-time and part-time, take an unpaid leave of absence, or go on strike.
- Change in dependent eligibility: a child ages out of coverage or gains or loses eligibility under another plan.
Federal rules don’t set a specific deadline for making the change, but most plan documents give you 30 days from the event. Miss the window and you generally wait until the next open enrollment. Check your own plan document, because some employers set shorter deadlines.7Internal Revenue Service. 26 CFR Part 1 – Tax Treatment of Cafeteria Plans – Section: Changes in Status
Life events aren’t the only trigger. If the cost of a benefit changes significantly during the year, the plan can allow you to adjust to match. When an insurance carrier raises premiums mid-year, for example, the plan may automatically increase your salary reduction or let you switch to a comparable lower-cost option.8eCFR. 26 CFR 1.125-4 – Permitted Election Changes Significant curtailment of coverage counts too: if your HMO leaves your area, a major hospital exits your network, or the plan drops a category of benefits, you can revoke and pick similar coverage. None of these cost-and-coverage rules apply to health FSAs, which stay locked regardless of price changes.
The Social Security Trade-Off
One downside rarely gets mentioned. Because pre-tax elections reduce the wages subject to Social Security tax, they also reduce the earnings the Social Security Administration uses to calculate your future retirement benefit. Every dollar routed through the plan is a dollar that doesn’t count toward your average indexed monthly earnings.
For most employees, the immediate tax savings far outweigh the small reduction in a future check. Someone contributing $3,000 a year to an FSA might see their eventual monthly benefit drop by a few dollars, while saving $890 or more in current taxes every year. The trade-off matters more for lower-income workers whose Social Security benefit will make up a larger share of retirement income. If your earnings sit below the Social Security wage base ($176,100 in 2025), every pre-tax dollar you contribute directly reduces the wages credited to your record.