Cafeteria Plan

An employee benefit plan that allows staff to choose from a variety of benefits to formulate a plan that best suits their needs.

Also known as "cafeteria employee benefit plan" or "flexible benefit plan".

Investopedia Says:
Similar to a cafeteria where individuals select their food of choice, employees may choose benefits of their choice. Plan options include health and accident insurance, cash benefits, tax advantages and/or retirement plan contributions.

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Plan offering employees numerous options among their employee benefits. Each employee is able to pick the benefits that are most valuable in his or her particular situation. For example, a young employee with children may want to receive more life and health insurance than a mid-career employee who is more concerned with building up retirement plan assets.

Employee benefit plan that allows the employee to choose among several different benefits offered by the employer. In essence, the employee is provided with the opportunity to make a trade-off by trading one benefit for another that best meets the employee's needs at a particular point in time. Contributions paid into the plan, whether on a Contributory or Noncontributory basis, can be allocated to satisfy the needs of a particular employee rather than those of the employees as a whole. The result should be a balance between the employee's primary needs and the benefit/cost constraints. Among the personal choices that the employee can make are health care plans (choices in types and amount of coverages). Wellness Program plans, child-care benefits, and Long-Term Care (LTC) Plans.

One permitting employees to choose from a variety of fringe benefits. The tax code provides that, with minor exceptions, no amount shall be included in the gross income of the participant in a cafeteria plan solely because the participant may choose among the benefits (including cash) of the plan.

Flexible benefit plans allow employees to choose the benefits they want or need from a package of programs offered by an employer. Flexible benefit plans may include health insurance, retirement benefits such as 401(k) plans, and reimbursement accounts that employees can use to pay for out-of-pocket health or dependent care expenses. In a flexible benefit plan, employees contribute to the cost of these benefits through a payroll deduction of their before-tax income, reducing the employer's contribution. In addition, the ability to pay for benefits with pre-tax income lowers an employee's taxable income while raising the amount of their take-home pay—an added "benefit." In the short term, companies obviously benefit from sharing costs with employees. But a business may also choose to cap its future contributions to benefits by passing along increased costs to employees through these plans.

Flexible benefit plans have become increasingly popular with employers. Health and child care costs have risen tremendously over the past several decades. This has had a major effect on a business' ability to offer benefits, yet most employees still expect to receive benefits as a result of employment. Small businesses in particular are often unable to take advantage of the economies of scale that larger companies can use to their advantage in securing benefits programs. These companies, as well as larger ones, have subsequently sought palatable means by which their employees can contribute to the cost of benefits. One option is a flexible benefit plan. Indeed, many businesses have begun to offer flexible benefits in order to retain a competitive benefits package for employees. There are several types of flexible benefit plans, including cafeteria plans and flexible spending accounts.

Cafeteria Plans

A type of flexible benefit plan known as a cafeteria plan enables employees to choose between receiving some or all of an employer's nontaxable benefits, or receiving cash or other taxable benefits such as stock. These plans were established by the Revenue Act of 1978 and are regulated by Section 125 of the Internal Revenue Code. Only certain benefits can be offered under a cafeteria plan, though employers may offer any or all of these benefits. These include: health and group life insurance as well as medical reimbursement plans for non-insured expenses; disability, dental, and vision coverage; day care or eldercare; 401(k) plans; and vacation days. Tuition assistance and other fringe benefits are exempt from the plans, even if they are not taxable. Funding for cafeteria plans may come from the employer, employee, or both. Often, the employee receives a spending credit, with which he or she may choose to "buy" benefits from a list of options such as health insurance, life insurance, etc. The benefits themselves may be provided in cash or via actual coverage.

In order to ensure these plans are fair to all employees and to limit the number of changes employees can make to their plan, the IRS has set up a number of restrictions. For example, employees are unable to carry over unused credits or benefits to the next plan year. In addition, employers need to be sure that no more than 25 percent of the tax-favored benefits go to "highly compensated" employees. These employees could be officers earning above a certain salary range or those who have a percentage of ownership in the company greater than 1 percent (if they earn over $150,000) or greater than 5 percent (for others).

Flexible Spending Accounts

A flexible spending account (FSA) is a tax-deferred savings account established by an employer to help employees meet certain medical and dependent care expenses that are not covered under the employer's insurance plan. FSAs allow employees to contribute pre-tax dollars to an account set up by their employer. They can later withdraw these funds tax-free to pay for qualified health insurance premiums, out-of-pocket medical costs, day care provider fees, or private pre-school and kindergarten expenses.

There are three main types of FSAs: premium-only plans, which allow employees to set aside funds to pay medical and life insurance premiums; unreimbursed medical expenses plans, which allow employees to set aside money for projected health care expenses not covered by insurance; and dependent care reimbursement plans, which allow employees to set aside money for day care of dependent children. Employees must prove they have a legitimate expense in order to be reimbursed from these accounts. Invoices from health care professionals or day care facilities would serve this purpose. However, employees must also prove that the claim has not been reimbursed by other coverage, such as a spouse's insurance. Funds placed in reimbursement accounts generally must be used during the calendar year in which they were contributed; otherwise, the employee forfeits the funds. For this reason, participating in a flexible spending account requires careful planning on the part of both employees and employers.

Set-Up and Tax Implications

A small business can manage its own flexible benefit plan with the proper software. Since these plans are under the watchful eye of the IRS, it is important that record keeping and benefit payments be accurate and timely. Many companies hire an outside firm to manage their plan, which reduces internal headaches but at a higher cost to the company. Some insurance companies also provide administrative services for flexible plans as well.

Employer contributions to cafeteria plans are tax deductible for the employer and are not subject to income tax for the employee. The contributions are taken before taxes, and therefore are not subject to Social Security (FICA) or federal unemployment (FUTA) taxes unless the monies are contributed to 401(k) plans. Many states follow the same guidelines regarding state taxes but companies should check with their accountant or the state's tax department to be sure.

Obviously, flexible benefit plans are not without their drawbacks. But for small businesses looking to attract and retain key personnel with competitive benefit packages while keeping their own costs low, they can be an attractive alternative to standard benefit plans. Further information about setting up and administering flexible benefit plans is available from the Employee Benefits Institute of America at www.ebia.com/cafeteria.html.

Further Reading:

"Flex Plan Enrollment Rules Eased." Employee Benefit News. February 1, 2001.

Gould, Jay. "Flexible Spending Accounts Benefit Both Employees, Employers." San Antonio Business Journal. November 24, 2000.

"How to Set Up a Cafeteria Plan." Capital District Business Review. December 11, 2000.

Hunt, Kelly A. "Survey Finds Flexible Benefits on the Rise, Particularly Among Public Employers." Government Finance Review. August 1997.

"Let's Be Flexible." Journal of Accountancy. March 1998.

White, Jane, and Bruce Pyenson. Employee Benefits for Small Business. Prentice Hall, 1991.

See also: Employee Benefits

Employee benefits plan in which employees select their medical insurance coverage and other nontaxable fringe benefits from a list of options provided by the employer. Cafeteria plan participants may receive additional, taxable cash compensation if they select less expensive benefits.