A Section 125 plan, also called a cafeteria plan, is an employer benefit arrangement that lets you pay for health insurance premiums, medical costs, and dependent care with pre-tax dollars. You agree to a small reduction in your gross pay, and that money moves into your chosen benefits before federal income tax, Social Security tax, and Medicare tax are calculated. The savings show up on every paycheck, and for 2026 the contribution ceilings for both health and dependent care accounts are higher than they’ve ever been.
How the Pre-Tax Mechanism Works
Everything runs off a salary reduction agreement. You tell your employer to lower your gross pay by a fixed amount each pay period, and that amount is routed directly to your premiums or benefit accounts. Because the reduction happens before payroll taxes are figured, you never pay federal income tax, Social Security tax, or Medicare tax on those dollars.1Internal Revenue Service. FAQs for Government Entities Regarding Cafeteria Plans
The FICA piece is where the numbers get interesting. The employee share of FICA is 7.65% of wages, made up of 6.2% for Social Security and 1.45% for Medicare.2Social Security Administration. SI 00820.102 Cafeteria Benefit Plans Every dollar you push through the cafeteria plan skips that 7.65%. Your employer skips a matching 7.65% on those same dollars, which is why so many employers are willing to set these plans up.
Consider an employee earning $60,000 who directs $3,400 to a health FSA and $3,000 to insurance premiums. That’s $6,400 sheltered from tax. At a combined federal and state marginal rate around 30%, income tax savings come to roughly $1,920, plus another $490 in FICA. The expenses were coming out of pocket anyway, so the tax benefit is real money kept.
What You Can Pay For
The Internal Revenue Code limits cafeteria plans to a specific list of “qualified benefits” that already get favorable tax treatment elsewhere in the code.3Office of the Law Revision Counsel. 26 USC 125 Cafeteria Plans Not everything an employer offers fits inside a Section 125 plan.
Premium Only Plans
The simplest and most common version lets you pay your share of employer-sponsored medical, dental, and vision premiums with pre-tax dollars. Many employers that offer group health insurance run a premium only plan even if they offer nothing else, because it saves both sides money with almost no administrative overhead.
Health Flexible Spending Accounts
A health FSA sets aside pre-tax money for out-of-pocket medical costs: copays, deductibles, prescriptions, glasses, and a long list of other eligible expenses. One important quirk is that your full annual election is available on the first day of the plan year, even though payroll deductions come out gradually. That front-loading is the health FSA’s biggest practical advantage over simply paying costs out of pocket.
Dependent Care FSAs
A dependent care FSA covers care expenses for a qualifying child under 13 or a disabled dependent who cannot care for themselves, so long as the care lets you and your spouse work or look for work.4Internal Revenue Service. Child and Dependent Care Credit Information Eligible costs include daycare, preschool, before- and after-school programs, and adult day care for a disabled dependent. Summer day camp counts. Overnight camp does not.
Unlike a health FSA, the full annual election is not available on day one. Reimbursements are limited to what you’ve actually contributed at the time of the claim.
HSA Contributions Through Payroll
A Health Savings Account is not itself a cafeteria plan benefit, but the two can be wired together. If you’re enrolled in a qualifying high-deductible health plan, your employer can route your HSA contributions through pre-tax payroll deductions inside the Section 125 plan. The advantage over contributing to an HSA on your own and taking the above-the-line deduction at tax time is that the payroll route also avoids FICA. That adds roughly 7.65% in savings that the deduction alone doesn’t recover.
Group Term Life and Adoption Assistance
Group term life insurance can be offered through the plan, but only the first $50,000 of employer-provided coverage is fully tax-free. Coverage above $50,000 creates imputed income subject to Social Security and Medicare taxes even when it runs through the cafeteria plan.5Internal Revenue Service. Group-Term Life Insurance Adoption assistance also qualifies, but it follows unusual rules: exempt from federal income tax, still subject to FICA.1Internal Revenue Service. FAQs for Government Entities Regarding Cafeteria Plans
What’s Excluded
Long-term care insurance cannot go through a Section 125 plan. Neither can educational assistance or tuition reimbursement, even though those benefits get favorable treatment under other parts of the tax code. The statute specifically carves out benefits under Sections 117, 127, and 132 from the qualified benefits definition.3Office of the Law Revision Counsel. 26 USC 125 Cafeteria Plans
2026 Contribution Limits
Dollar limits are adjusted for inflation, and 2026 brings increases across the board:
- Health FSA salary reduction: $3,400 maximum, up from $3,300 in 2025.6FSAFEDS. Message Board – 2026 HCFSA Contribution Limit
- Health FSA carryover: up to $680 of unused funds can roll into the next plan year if the employer’s plan allows it, up from $660.
- Dependent care FSA: $7,500 per household, or $3,750 if married filing separately.7Office of the Law Revision Counsel. 26 USC 129 Dependent Care Assistance Programs
- Group term life: first $50,000 of coverage tax-free. This figure is set by statute and does not adjust for inflation.5Internal Revenue Service. Group-Term Life Insurance
The dependent care jump is the headline. The $5,000 cap had stood for decades. Congress raised it to $7,500 effective for tax years beginning after December 31, 2025, which means families paying for childcare can shelter substantially more income starting with the 2026 plan year.
Locking In Elections and Making Mid-Year Changes
You choose your benefits during your employer’s annual open enrollment period, usually a few weeks before the new plan year starts. Once you elect, those choices are locked in for the full 12 months. That irrevocability is central to how the plan keeps its tax-favored status.3Office of the Law Revision Counsel. 26 USC 125 Cafeteria Plans
The IRS allows mid-year changes when you have a qualifying life event, but only if your employer’s plan document permits changes for that specific event. Common qualifying events include:
- Marriage or divorce, which lets you add or drop a spouse’s coverage.
- Birth or adoption of a child, which lets you add the child and increase FSA elections.
- A change in employment status for you or your spouse.
- Loss of other coverage, such as your spouse’s employer dropping health insurance.
The change has to be consistent with the event. Losing a spouse’s dental plan doesn’t justify dropping your own medical coverage. Most employers require the change request within 30 days of the event, though certain Medicaid and CHIP events carry a 60-day window. Miss the deadline and you’re waiting until the next open enrollment.
Use It or Lose It
Health FSAs and dependent care FSAs run on a strict use-it-or-lose-it rule. Any balance left at the end of the plan year is forfeited to the employer.8Internal Revenue Service. Publication 969 (2025), Health Savings Accounts and Other Tax-Favored Health Plans This is the single biggest risk of participating, and the reason most people underestimate their elections rather than overestimate.
The IRS lets employers soften the rule by picking one of two relief options, but not both:9Internal Revenue Service. IRS – Eligible Employees Can Use Tax-Free Dollars for Medical Expenses
- A grace period, giving you an extra two and a half months after plan-year end to incur new eligible expenses using leftover funds. For a calendar-year plan, that runs through March 15.
- A carryover, letting up to $680 of unused health FSA funds (for 2026) roll into the next plan year automatically. Anything above $680 is still forfeited, and the carryover doesn’t reduce what you can elect for the new year.
Your employer chooses. You don’t. If the plan offers a carryover, treat $680 as your safety margin when setting your election. If it offers a grace period, you have a short window to schedule dental work or stock up on eligible items before the balance disappears.
A grace period is not the same thing as a run-out period. A run-out period, typically 90 days, is just extra time to submit reimbursement claims for expenses already incurred during the plan year.10Internal Revenue Service. Section 125 – Cafeteria Plans – Modification of Application of Rule Prohibiting Deferred Compensation Many plans offer both a run-out period and either a grace period or carryover.
What Happens When You Leave Your Job
Participants get caught off guard here more than anywhere else. When you leave, your salary reduction contributions stop, and your FSA participation generally ends on your termination date. For a health FSA, you can only submit claims for expenses incurred before your last day. Any remaining balance is forfeited under the use-it-or-lose-it rule.
If you’ve spent more from your health FSA than you’ve contributed, you keep the benefit. Because the full annual election is available from day one, an employee who elected $3,400 but leaves in March after only $850 in payroll deductions can still submit claims up to $3,400 for expenses incurred before termination. If $2,000 has already been reimbursed, the employer absorbs the $1,150 shortfall.
COBRA continuation can technically apply to a health FSA, but it rarely makes sense. An employer only has to offer FSA COBRA if the account is “overspent” at the qualifying event, meaning you’ve been reimbursed more than you’ve contributed.11U.S. Department of Labor. FAQs on COBRA Continuation Health Coverage for Workers If it’s underspent, COBRA is generally not required. Even when offered, electing COBRA means paying the full contribution plus a 2% administrative fee without pre-tax treatment, which wipes out most of the point.
Dependent care FSAs work differently. Since reimbursement is capped at what you’ve actually contributed, there’s no overspent scenario. You can still submit claims for expenses incurred during the period your contributions covered.
A Note on State Taxes
Most states follow the federal treatment and exclude cafeteria plan contributions from state income tax. A small number of states do not, taxing salary reduction contributions at the state level regardless of the federal exclusion. If you live in one of those states, your gross salary before cafeteria deductions is still your taxable income for state purposes. Federal income tax and FICA savings stay intact, so the plan is still worth participating in, but your total savings will run a little lower than a federal-only estimate suggests. Your payroll department handles the different withholding automatically.