The Internal Revenue Code (IRC), Section 125(d), defines a cafeteria plan as a separate written document which gives participants the choice between cash (a taxable benefit) and at least one other benefit the Internal Revenue Service (IRS) calls a qualified benefit (a nontaxable benefit), which is not included in the participants’ income for federal tax purposes. The plan document governs contributions to and participation in other benefit plans, and only employees may participate. You may think of it as the master document that contains a collection of benefit plans offering a menu of benefits. The type of cafeteria plan that is set up, whether very simple or more complex, will make a difference in the cost of administration. Regardless of the design, the IRS determines which benefits may be offered in a cafeteria plan.

Examples of qualified (or nontaxable) benefits that may be offered under a cafeteria plan include accident and health insurance, group-term life insurance up to $50,000, business travel accident insurance, coverage under a medical and/or dependent care flexible spending account, and 401(k) contributions. Employers also can provide certain taxable benefits, paid for using after-tax dollars, including group automobile insurance, group homeowners insurance, vacation days, and cash. Although these benefits are taxable, they still are considered benefits since the employee may not otherwise have access to them (in the case of additional vacation days and cash) or may not be able to purchase them at the rate the employer can (in the case of insurance).

On the other hand, a cafeteria plan may not offer scholarships and fellowships, transportation benefits, educational assistance, employee discounts, and retirement benefits that defer the receipt of benefits beyond the taxable year (other than participation in a 401(k) plan mentioned above).

Depending on the structure of the plan, the employee may pay for benefits under the cafeteria plan, the employer may pay, or both may pay a portion of the cost. If the employer pays part of the cost, it may give the employee a certain number of dollars and the employee must pay the difference for the benefits he chooses.

A big advantage for employees is that cafeteria plans allow them to choose the benefits they need. For example, if an employee needs new glasses or would like to have cosmetic surgery, he can put pre-tax dollars into a health care spending account and purchase these items within the plan year without paying federal taxes on money used for the purchase. Or, if an employee is covered by a spouse’s medical plan, he may decide to opt out of medical insurance and purchase additional life insurance. In case the employee has a change in family status during the year (for example, marries or has a baby), he may have the option of changing his benefit choices to reflect the change in family needs.

In addition, employees can reduce their payroll taxes by purchasing qualified benefits with pre-tax dollars. Because those benefits are not taxable, the employee does not have to pay federal income tax and social security tax on the dollars used to purchase them.

Among the advantages for employers is saving on payroll taxes. The employee pre-tax payments will lower the employer’s overall payroll and, as a result, will lower payroll-related taxes. In addition, there may be a cost saving to the employer because the cost of benefits that employees do not want will be eliminated. Employers that currently pay the cost of benefits for employees also may choose to shift some or all of the cost to employees through a salary deferral arrangement (the employee’s salary is reduced or deferred to pay for the benefit) by giving the employee a certain number of dollars to spend on benefits of his choice. If the cost of the employee’s benefits exceeds the dollars received from the employer, the difference is deducted from the employee’s salary. Even if the cost of benefits increases in successive years, the employer can keep its cost constant by raising the employees’ share of the premiums. Finally, cafeteria plans may help attract and retain employees because they like the element of choice and the tax advantages.

One potential downside of cafeteria plans is the possibility of “adverse selection,” the selection of a specific benefit by those who are most likely to use it extensively while those who are not likely to use it do not choose the benefit. For example, when a group of employees who have costly medical needs all select the same medical plan, claims under the plan will increase. With higher claims to pay, the cost of the insurance also will increase, causing healthy employees to choose not to participate in this benefit. As a result, the price of the insurance may increase so much it is no longer practical for the employer to maintain the plan. Another disadvantage is the complexity and cost of administration since employers must comply with the extensive regulations that govern cafeteria plans, including tax nondiscrimination rules and the Employee Retirement Income Security Act (ERISA) reporting and disclosure requirements.

If you are considering a cafeteria plan, perhaps the most important first step is to determine whether such a plan is feasible for your organization, based on the goals of the employer and the needs of the employees. Many employers conduct a study of the design and cost of the benefits and use a benefits consultant specializing in cafeteria plans. You also should analyze your employees’ demographics. Their ages, marital status, and number of dependents will influence the cost and desirability of the benefits to be offered. In addition, if the organization has insurance carriers, you should consider the feasibility of offering current plans under the cafeteria structure.

The success of a new cafeteria plan depends on planning, which may take as much as a year or more. One approach is to offer only the basic health benefits at first. If the employees like the idea, the plan can be expanded later. By researching the benefits and listening to your employees’ needs, you can create the plan best suited to your organization.