What Is a Section 125 Cafeteria Plan: Pre-Tax Benefits and FSAs

A Section 125 cafeteria plan is an employer-sponsored benefit arrangement that lets you pay for health insurance premiums, certain medical expenses, and dependent care with pre-tax dollars, lowering your federal income tax, Social Security and Medicare taxes, and usually your state income tax. The name comes from Section 125 of the Internal Revenue Code, which gives you a choice between taking your full salary in cash or redirecting part of it toward qualified benefits before taxes are calculated.¹ The plan must be a written document, and only employees of the sponsoring employer can participate.

How the Pre-Tax Savings Actually Work

At the center of every cafeteria plan is a salary reduction agreement. You agree to lower your gross pay by a set amount each pay period, and your employer applies that money to the benefits you picked. Because the redirected wages never count as part of your gross income, three layers of tax fall away.

Federal income tax comes off first. The amount you divert avoids your marginal rate, which for 2026 runs from 10% to 37%.² FICA comes off next. You normally pay 7.65% of your wages toward Social Security (6.2%) and Medicare (1.45%), and pre-tax cafeteria contributions reduce the wages those taxes apply to.³ Most states that levy an income tax follow the federal treatment and exclude cafeteria contributions from taxable wages, though a handful do not.

Your employer benefits too, because the wages you redirect also shrink the employer’s matching FICA on each dollar. One rule matters for timing: the salary reduction agreement has to be made before you earn the income. You cannot reclassify wages you have already received.¹

Which Benefits You Can Pay for Pre-Tax

The IRS limits cafeteria plans to a defined list of “qualified benefits.” The common ones are:

Health, dental, and vision insurance premiums under an employer-sponsored group plan. This is the most widely used cafeteria benefit.
Health flexible spending accounts, funded with pre-tax dollars to reimburse eligible medical, dental, and vision expenses not covered by insurance.
Dependent care flexible spending accounts, which reimburse child care or elder care expenses that let you and your spouse work.
Group-term life insurance up to $50,000 in coverage. Coverage above $50,000 produces taxable income to you.⁴
Adoption assistance for qualifying costs such as legal fees, court costs, and travel.
Health savings account contributions, if you are enrolled in a qualifying high-deductible health plan. Your employer can route pre-tax payroll deductions into your HSA through the cafeteria plan.

Long-term arrangements like 401(k) contributions and other deferred compensation generally cannot run through a cafeteria plan, with narrow exceptions for certain retirement arrangements.¹

Health FSA Rules and 2026 Limits

A health FSA lets you set aside pre-tax money for copays, prescriptions, and dental or vision costs your insurance doesn’t fully cover. For 2026, the maximum contribution is $3,400, and the limit is adjusted for inflation each year.²

The catch is the use-it-or-lose-it rule. Any money left in the account at the end of the plan year is forfeited. Two forms of relief exist, and an employer can offer one but not both:

Carryover of up to $680 of unused funds into the following plan year for 2026.²
A grace period of two and a half months after plan year end to spend down the remaining balance on eligible expenses.

Your employer decides which option, if any, to offer. Estimate expenses carefully rather than contributing the maximum just to capture the tax break.

Health FSA and HSA Together

If you have a high-deductible health plan and want to contribute to a health savings account, a standard health FSA generally disqualifies you from making HSA contributions. The workaround is a limited-purpose FSA, which restricts reimbursements to dental and vision expenses and preserves your HSA eligibility.

Dependent Care FSA Rules and 2026 Limits

A dependent care FSA pays for child care, day camp, preschool, or elder care that lets you and your spouse work. For 2026, the household maximum is $7,500, or $3,750 if you are married and filing separately.⁵ That is a jump from the previous $5,000 limit, which had stood since 1986, and it applies to tax years beginning after December 31, 2025.

The forfeiture rule applies here too. Federal law does not build in a separate carryover for dependent care FSAs the way it does for health FSAs, though some plans offer a grace period. One planning note: dependent care FSA reimbursements reduce the amount you can claim under the child and dependent care tax credit, so compare both before committing to a large election.

Enrolling and Changing Your Elections

Most employers hold open enrollment once a year, usually a two-to-four-week window. During that time you pick your benefits and set your contribution amounts for the coming plan year. You will typically choose a coverage level for health insurance, decide whether to fund a health FSA, dependent care FSA, or both, complete a salary reduction agreement locking in the dollar amounts per benefit, and supply names and Social Security numbers for any dependents you cover. Once enrollment closes, your elections generally hold for the full plan year, and payroll deductions start with the first check of the new year.

Mid-year, you can change elections only if you have a qualifying life event recognized by IRS regulations, and the change has to be consistent with the event. You cannot drop health coverage after having a baby, for example, but you can add the newborn. Qualifying events include:⁶

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 for you or a covered family member: starting or losing a job, moving between full-time and part-time, unpaid leave, or a strike or lockout.
Change in dependent eligibility, such as a child aging out or losing student status.
Change in residence that affects your available plan options.

You typically have 30 days from the qualifying event to request the change. For events that trigger special enrollment under federal health plan rules, such as marriage, birth, or loss of other coverage, that 30-day window comes from HIPAA’s special enrollment provisions.⁷ Your plan document may set its own deadlines, so contact your benefits administrator right away after any life change.

Who Cannot Participate

Cafeteria plans are for common-law employees. Full-time workers are the primary participants, and employers can extend eligibility to part-timers through the plan document. Several categories of workers are excluded by law, mostly to keep the plan from becoming a tax shelter for owners:

Self-employed individuals, including sole proprietors and partners in a partnership.
S corporation shareholders who own more than 2%, who are treated as self-employed for this purpose.
Members of an LLC that is not taxed as a C corporation, in most cases.

If you leave a job with money still in a health FSA, your employer may have to offer COBRA continuation for the FSA through the end of the plan year. Without electing COBRA, you forfeit the remaining balance, other than claims incurred before your termination date.

The Social Security Trade-Off

One long-term cost of cafeteria contributions rarely gets mentioned at open enrollment. Because your salary reduction lowers your taxable wages, it also lowers the earnings the Social Security Administration credits to your record for that year.⁸ Social Security retirement benefits are calculated from your highest 35 years of indexed earnings, so every dollar you divert slightly reduces the wages counted for that year.

For most workers the immediate tax savings outweigh the small hit to future benefits. If you are in your peak earning years or close to retirement and trying to maximize your benefit, factor this in before pushing your contributions to the maximum. The same logic reaches disability benefits and any other income-based calculation tied to your reported wages.

1
Office of the Law Revision Counsel. 26 USC 125 – Cafeteria Plans
2
Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026
3
Social Security Administration. 2026 Cost-of-Living Adjustment (COLA) Fact Sheet
4
Internal Revenue Service. Group-Term Life Insurance
5
Office of the Law Revision Counsel. 26 U.S. Code 129 – Dependent Care Assistance Programs
6
eCFR. 26 CFR 1.125-4 – Permitted Election Changes
7
Department of Labor. FAQs on HIPAA Portability and Nondiscrimination Requirements
8
Social Security Administration. POMS SI 00820.102 – Cafeteria Benefit Plans