Section 125 cafeteria plans: premium-only plans, FSAs and 2026 limits

A Section 125 cafeteria plan is a written employer plan that lets employees choose between taxable cash and certain tax-free benefits, so the benefits they pick are paid with pre-tax salary. Done correctly, the employee skips income tax and payroll tax on the amount, and the employer skips its own payroll tax. The plan must be in writing, limited to permitted benefits, and tested for discrimination, and a plan that breaks the rules can lose its tax treatment.

The three common versions

• Premium-only plan (POP). The simplest version. Employees pay their share of group health, dental and vision premiums with pre-tax salary. Most small employers who use payroll deduction for health premiums should have at least this.
• Flexible spending arrangements (FSAs). A health FSA reimburses medical expenses; a dependent care FSA reimburses child or adult dependent care. Both are funded by salary reduction through the cafeteria plan.
• Full cafeteria plan. Adds HSA contributions, adoption assistance and group-term life, and may offer cash.

A small employer can also adopt a simple cafeteria plan, a safe harbor that skips the nondiscrimination testing in exchange for mandatory employer contributions (see below).

What the plan can and cannot include

According to IRS Publication 15-B (2026), a cafeteria plan may include accident and health benefits (but not Archer MSAs or long-term care insurance), adoption assistance, dependent care assistance, group-term life insurance, and employee contributions to an HSA. A qualified 401(k) plan can also be offered as a cash-or-deferred option within a cafeteria plan.

The same publication lists benefits a cafeteria plan cannot include. Among them: educational assistance, de minimis benefits, employee discounts, employer-provided cell phones, meals, lodging on business premises, no-additional-cost services, transportation (commuting) benefits, tuition reduction, working condition benefits and athletic facilities. Qualified transportation is handled under a separate employer program: for 2026 the monthly exclusion is $340 for qualified parking and $340 for commuter highway vehicle and transit passes. HDHPs and HSAs: an employer guide with 2026 limits covers how HSAs sit alongside the plan, and group-term life over $50,000: imputed income and how to calculate it covers the $50,000 imputed income rule for group life offered through a cafeteria plan.

2026 limits that matter

• Health FSA salary reduction. For plan years beginning in 2026, a cafeteria plan may not allow salary reductions for a health FSA above $3,400 (IRS Publication 15-B (2026), Rev. Proc. 2025-32). The IRS states that a plan that does not impose the limit "isn't a cafeteria plan" and all benefits become taxable.
• Health FSA carryover. If the plan allows carryover instead of a grace period, the maximum carryover is $680 for 2026 (Rev. Proc. 2025-32). A plan can offer a grace period of up to 2.5 months or a carryover, not both.
• Dependent care assistance. The annual exclusion rose from $5,000 to $7,500 ($3,750 for married individuals filing separately) for 2026 under the 2025 budget law, P.L. 119-21, as noted in Publication 15-B.
• HSA contributions. For 2026, HSA limits are $4,400 for self-only and $8,750 for family coverage, with a $1,000 catch-up at age 55 (Rev. Proc. 2025-19). Employer contributions through a cafeteria plan are not subject to the comparability rules that apply outside one.
• Key employee definition. For 2026, an officer with annual pay over $235,000, a 5% owner, or a 1% owner with pay over $150,000.

Rules that trip employers

1. Written plan document

The plan must be written, describe the benefits, the eligibility rules, the election procedures and the plan year, and be adopted before the benefits are paid. An employer who simply deducts premiums pre-tax without a document is the classic audit finding. Many carriers and payroll vendors supply a POP template, but the employer, not the vendor, is responsible for adopting and following it. Review it when you change carriers or add an FSA.

2. Elections are irrevocable except for qualifying events

Employees make elections before the plan year and cannot change them mid-year unless there is a permitted change in status, such as marriage, divorce, birth or adoption, death of a dependent, a change in employment status that affects eligibility, a significant change in cost or coverage, or a loss of other coverage. The change must be consistent with the event. The plan can be more restrictive than the IRS regulations (Treas. Reg. 1.125-4), but cannot be looser. Document each change.

3. Nondiscrimination

A cafeteria plan fails if it favors highly compensated employees as to eligibility, contributions or benefits. Publication 15-B defines a highly compensated employee for this purpose as an officer, a shareholder owning more than 5% of voting power or value, an employee who is highly compensated on the facts and circumstances, or a spouse or dependent of one of those. If the plan favors key employees, so that more than 25% of the nontaxable benefits go to key employees, those employees must include in wages the taxable benefits they could have chosen. Plans under a collective bargaining agreement are exempt from these tests.

4. Owners and S corporation shareholders

A 2% shareholder of an S corporation, as defined in the publication (someone who owns more than 2% of the stock or voting power), is not treated as an employee for this purpose and is treated like a partner for fringe benefit purposes. Sole proprietors and partners cannot participate in a cafeteria plan. This matters for small employers where the owners are the main users of the plan: the owners may need a different path, such as a QSEHRA for employees (QSEHRA explained: the small employer HRA, 2026 limits and rules) and a separate arrangement for themselves. Confirm with a CPA.

5. Uniform coverage and use-or-lose

The health FSA's full annual election must be available from day one regardless of what the employee has contributed so far, which is the uniform coverage rule. The plan carries the risk of over-reimbursement and benefits from forfeited balances, which employees can lose if they do not use the money by plan year-end (or after the grace period or carryover). Publication 15-B describes the grace period and carryover alternative.

Simple cafeteria plans

Employers with an average of 100 or fewer employees in either of the two preceding years can adopt a simple cafeteria plan, which is treated as meeting nondiscrimination requirements for the cafeteria plan and for certain benefits under it. A new business qualifies if it expects to average 100 or fewer employees. An employer that establishes a simple plan remains eligible until the year after it employs an average of 200 or more employees.

In return the employer must satisfy two requirements from Publication 15-B:

• Eligibility and participation. All employees with at least 1,000 hours of service in the preceding plan year are eligible, and may elect any benefit offered. The plan may exclude employees under 21, with less than one year of service, covered by a collective bargaining agreement that was bargained, or nonresident aliens with no U.S.-source income.
• Contribution. The employer must contribute for each qualified employee either a uniform percentage (not less than 2%) of compensation, or an amount at least equal to the lesser of 6% of compensation and twice the employee's own salary reduction.

Worked example (hypothetical)

Say a 30-employee dental practice pays $600 a month for each employee's single health premium, and employees elect family coverage, with a $400 monthly contribution through payroll. Without a cafeteria plan the $400 is deducted from after-tax wages. With a POP the $400 comes out pre-tax. For an employee in a 22% federal bracket, that saves $88 a month in federal income tax before state tax, plus 7.65% in FICA, $30.60 a month. The employer saves its own 7.65% share of FICA on the same $400. Across a staff with 20 people electing the same, that is roughly $7,300 a year of employer payroll tax saved (20 x $30.60 x 12), which pays for plan administration many times over. These figures illustrate the mechanism and are not typical savings.

Compliance steps checklist

1. Adopt a written plan document before the plan year starts and keep a signed copy.
2. Decide the benefits (POP, health FSA, dependent care FSA, HSA).
3. Set the election window and communicate the irrevocability rule.
4. Cap health FSA elections at $3,400 and decide whether to use the grace period or carryover.
5. Run the annual nondiscrimination tests or adopt the simple plan.
6. Track mid-year change requests against the permitted events.
7. If the plan includes a health FSA covering 100 or more participants, add it to your Form 5500 analysis (form 5500 for health and welfare plans: who files and when), and read ERISA basics for small employers: what the law requires of your benefit plans for the plan-document and notice duties that apply to the underlying health plan.

Key takeaways

• A cafeteria plan is valid only if written, limited to permitted benefits, and followed; a payroll deduction without a document is the common failure.
• For 2026, the health FSA limit is $3,400 with a $680 maximum carryover, and the dependent care limit is $7,500.
• Commuter benefits, educational assistance, employee discounts and similar fringe benefits cannot be offered through a cafeteria plan.
• Elections are irrevocable unless a permitted change in status occurs, and key employees and 2% S corporation shareholders are treated differently.
• Employers with 100 or fewer employees can use a simple cafeteria plan, which trades testing for a minimum employer contribution.