IRC 125 Cafeteria Plans: Benefits, 2026 Limits, and Compliance

A Section 125 cafeteria plan is an employer-sponsored arrangement that lets you pay for health insurance, flexible spending accounts, dependent care, and a handful of other workplace benefits with pre-tax dollars, cutting your federal income tax, Social Security tax, and Medicare tax at the same time. The name comes from Section 125 of the Internal Revenue Code, which creates a narrow exception to the usual rule that any benefit you could have taken as cash is taxable as if you did. To hold onto that tax treatment, the plan has to follow specific federal rules covering qualified benefits, elections, contribution caps, nondiscrimination, and documentation.

How the Pre-Tax Mechanic Works

Ordinarily, if your employer offers you a choice between cash and a benefit, the IRS taxes you on the full amount whether you take the cash or not. Section 125 removes that trap for a properly structured cafeteria plan: when the choice is offered through the plan, you owe no tax on the benefit simply because cash was an option.¹

The savings show up on both sides of the paycheck. Money you redirect into a qualified benefit is excluded from federal income tax, Social Security, and Medicare.² Your employer avoids its share of FICA and federal unemployment tax on the same dollars, which is why even small businesses often set these plans up.

Benefits You Can Pay For Through the Plan

A cafeteria plan can only offer benefits that another section of the tax code specifically excludes from income.¹ In practice, that means a familiar list:

Employer group health coverage, including medical, dental, and vision premiums. The simplest version, a Premium Only Plan (POP), does nothing more than let employees pay their share of premiums pre-tax.
Health Flexible Spending Accounts, which reimburse out-of-pocket medical costs like copays, prescriptions, and glasses.
Dependent Care Assistance accounts, which cover child care or elder care needed for you (and your spouse, if married) to work.
Group-term life insurance, tax-free on the first $50,000 of coverage; anything above that generates taxable imputed income.³⁴
Adoption assistance. Note that adoption assistance remains subject to Social Security, Medicare, and FUTA even though it’s excluded from income tax.²
Health Savings Account contributions, when the employee is enrolled in a qualifying High Deductible Health Plan and stays within HSA annual limits.

What the Plan Cannot Cover

The statute draws hard lines. The broadest is the ban on deferred compensation: a cafeteria plan cannot include any benefit that lets you receive value in a later year. Three exceptions exist. Contributions to a 401(k) can run through the plan, HSA contributions are allowed, and educational institutions can offer certain post-retirement group life insurance arrangements.¹

Two other exclusions catch employers by surprise. Long-term care insurance cannot be offered as a qualified benefit even though it looks like a natural fit next to health coverage. And individual health plans purchased through an Affordable Care Act marketplace are generally out, except for a narrow carve-out for qualifying small employers offering group coverage through an exchange.¹

2026 Contribution Limits

Several benefits inside a cafeteria plan have annual dollar caps that adjust for inflation. For the 2026 plan year:

Health FSA salary reductions are capped at $3,400. If the plan allows a carryover, the carryover cap is $680.⁵
Dependent Care FSA contributions max out at $7,500 per household, or $3,750 if married filing separately.⁶
Group-term life insurance stays tax-free on the first $50,000 of employer-provided coverage. That figure is set by statute and does not adjust for inflation.⁴

These caps apply per employee, not per plan. If you’re covered by cafeteria plans at two employers in the same year, the combined amount still can’t exceed the limit.

Locking In Elections and Mid-Year Changes

The core election rule is irrevocability. You make your choices before the plan year starts, and they’re locked in for twelve months. Wanting to drop dental in March or bump up your FSA in July isn’t enough on its own.

The exception is a qualifying life event, which the regulations call a permitted election change. These are specific personal changes that unlock a mid-year adjustment: marriage or divorce, birth or adoption of a child, a change in your spouse’s employment or coverage, and gaining or losing eligibility for other health coverage. The new election must be consistent with the event. Adopting a child, for example, supports switching from individual to family health coverage.⁷

Two practical details. First, the plan document has to name which events it recognizes; an employer is not required to allow every permitted change the regulations list. Second, you have a short window after the event to request the change with documentation. Miss it and the administrator has to say no to protect the plan’s tax status.

The Use-It-Or-Lose-It Rule

Money left in a health FSA or dependent care FSA at the end of the plan year is generally forfeited to the employer. The IRS has softened this over time for health FSAs, but the default remains that unspent funds go back to the employer.

Employers can adopt one of two relief options for health FSAs, but not both:

A grace period of up to two and a half months after the plan year ends during which employees can incur new expenses against last year’s balance. For a calendar-year plan, that pushes the deadline to March 15.⁸
A carryover of up to $680 of unused health FSA funds into the next plan year. Any balance above $680 is still forfeited.⁹

A plan cannot offer both a grace period and a carryover for the same FSA.⁹ Dependent care FSAs can use a grace period but are not eligible for carryover. Whichever option the employer picks, it has to apply uniformly to everyone in the plan.

What Happens to Your FSA When You Leave

Unused health FSA funds are forfeited when you leave your employer unless you elect COBRA continuation coverage for the FSA itself.⁹ COBRA lets you keep using the account through the end of the plan year by paying the full contribution plus a 2% administrative fee out of pocket.

Dependent care FSAs are not eligible for COBRA. When you leave, you usually get a limited run-out period to submit claims for expenses you incurred while still covered, and any balance after that is forfeited. The exact deadline varies by plan, so it’s worth reading the plan document before your last day.

Nondiscrimination Testing

The IRS does not let cafeteria plans quietly become tax shelters for executives. Three nondiscrimination tests apply, and failing them has real consequences.¹

The eligibility test asks whether enough non-highly-compensated employees can participate.
The contributions and benefits test looks at whether actual usage tilts too far toward highly compensated individuals.
The key employee concentration test limits key employees to no more than 25% of the plan’s total nontaxable benefits.¹

When a plan fails, the highly compensated or key employees lose the pre-tax treatment of their elected benefits and have to include those amounts in gross income for the year. Everyone else keeps their tax treatment. Testing runs as of the last day of the plan year, and small employers with a few highly paid owners fail the concentration test most often because those owners represent a large share of the participant pool.

The Simple Cafeteria Plan for Small Employers

Employers with 100 or fewer employees can sidestep nondiscrimination testing by adopting a “simple cafeteria plan.” If the plan meets the requirements, it’s automatically treated as passing all the nondiscrimination tests, including the separate ones for health FSAs, dependent care FSAs, and group-term life insurance.¹

The trade-off is a mandatory employer contribution. Either a uniform contribution of at least 2% of each eligible employee’s compensation, or a match of at least the lesser of 6% of compensation or twice the employee’s salary reduction.¹ The match rate for highly compensated and key employees cannot exceed the rate for other employees, and any employee with at least 1,000 hours of service in the preceding plan year must be eligible.

The Written Document and Payroll Reporting

A cafeteria plan must be a formal written document adopted before the plan takes effect. This cannot be handled after the fact. The document has to spell out the benefits offered, who is eligible, how and when elections are made, and which qualifying events allow mid-year changes.² Running a cafeteria plan without a written document is one of the most common compliance failures, and the IRS treats the plan as if it never existed.

The cafeteria plan itself doesn’t require a Form 5500. But the welfare benefits funded through it may. An ERISA-covered group welfare plan with 100 or more participants at the start of the plan year has to file Form 5500 annually.¹⁰ Smaller plans are generally exempt.

On payroll, salary reductions run through the cafeteria plan are excluded from wages in Boxes 1, 3, and 5 of the W-2, reflecting exclusion from income tax, Social Security, and Medicare.² Over-reporting means the employee overpays tax; under-reporting can draw penalties on audit.

What Non-Compliance Costs

When a cafeteria plan falls out of compliance, the IRS can retroactively strip its tax-advantaged treatment. Employees who thought they were paying pre-tax suddenly owe income and employment taxes on those amounts, and the employer owes its share of FICA and FUTA plus potential penalties for failing to withhold and report correctly.

The severity depends on the mistake. A qualification failure, such as never having a written plan document, can cause the IRS to treat the plan as if it never existed. An operational error, like reimbursing an ineligible expense from a health FSA, is judged on whether it was an isolated slip or a pattern. Nondiscrimination failures hit only the highly compensated and key employees; rank-and-file participants keep their tax treatment. Correcting errors quickly and reversing incorrect transactions as far as possible is what the IRS looks for when deciding how hard to press on penalties.

1
Office of the Law Revision Counsel. 26 USC 125 – Cafeteria Plans
2
Internal Revenue Service. FAQs for Government Entities Regarding Cafeteria Plans
3
Internal Revenue Service. Group-Term Life Insurance
4
Office of the Law Revision Counsel. 26 USC 79 – Group-Term Life Insurance Purchased for Employees
5
FSAFEDS. New 2026 Maximum Limit Updates
6
Office of the Law Revision Counsel. 26 USC 129 – Dependent Care Assistance Programs
7
eCFR. 26 CFR 1.125-4 – Permitted Election Changes
8
Internal Revenue Service. Notice 2005-86 – Health Savings Account Eligibility During a Cafeteria Plan Grace Period
9
Internal Revenue Service. Notice 2013-71 – Modification of Use-or-Lose Rule for Health Flexible Spending Arrangements
10
Internal Revenue Service. Form 5500 Corner