Merritt Personal Lines Manual: Cafeteria Plans

Congress first authorized cafeteria plans in 1978, as part of the Internal Revenue Code (Section 125). (Cafeteria plans are also known as "flexible-spending accounts" and "Section 125 plans.") A company can set up a cafeteria plan for its employees. This allows the employees to pay for a full menu of medically oriented expenses with pre-tax dollars. This not only reduces taxable income for employees, which can make the benefits virtually free - it also reduces taxable payroll for the employer.

If your employer offers a cafeteria plan, you choose the amount you would like to have withheld from each paycheck. If you typically spend $200 a month on child care and another $50 on prescription co-payments, for example, you might elect to have $250 a month withheld from your paycheck. If you also have annual expenses for glasses, co-payments for checkups, dental visits and so on, you can have an additional amount deducted each month to cover these costs, as well.

This money is placed into an escrow account. Whenever you have a medical cost that is not covered by your insurance, you submit a claim to the company that manages your employer's cafeteria plan and that firm debits your account and sends you a check.

A cafeteria plan can be a very good way to save money on health care costs. However, the key is to avoid having too much money deducted from your paychecks. Whatever money you put into a cafeteria plan each year must be used for health care costs. If there is money left over, it cannot be rolled over into the account for the following year or returned to you. As far as you're concerned, it's gone forever.

The chart below illustrates why you might want to pay for medical expenses you already have with pre-tax dollars.

The Benefits of Using a Cafeteria Plan

Without a Cafeteria Plan

Gross Salary -- $1,600.00
Federal & State Taxes -- $221.82
Social Security (FICA) -- $122.40
Less Medical Premium -- $110.60
Less Medical Expenses -- $60.00
Less Dependent Care -- $200.00
Spendable Income -- $885.18

With a Cafeteria Plan

Gross Salary -- $1,600.00
Federal & State Taxes -- $135.43
Social Security (FICA) -- $94.05
Less Medical Premium -- $110.60
Less Medical Expenses -- $60.00
Less Dependent Care -- $200.00
Spendable Income -- $999.92

Source: Cynthia Pogue Baker, CPA