Section 125 Cafeteria Plan – Employer Checklist

This checklist is based exclusively on IRS authority (Section 125, IRS regulations, and IRS publications) and includes relevant internal resources from AccountingPortal.com.

1. Determine Eligibility and Plan Purpose

• Confirm that a cafeteria plan must be a written plan maintained by the employer for employees under IRC §125.
  See IRS guidance in Publication 15-B.
• Ensure participants are employees. Owners such as partners and more-than-2% S-corp shareholders generally cannot participate.
• Review the fundamentals of cafeteria plans:
  Cafeteria Plan – Fringe Benefits (AccountingPortal).

2. Prepare the Written Section 125 Plan Document

• The written plan must specify:
  • Plan eligibility and participation rules (employees only)
  • Benefit options offered
  • Election procedures and deadlines
  • Salary reduction agreements
  • FSA rules (uniform coverage rule, use-it-or-lose-it, carryover or grace period)
  • Rules for mid-year election change events under IRS regulations
  • Nondiscrimination compliance for highly compensated and key employees
• IRS authority for written plan requirements is in Treas. Reg. §1.125-1 and IRS publications:
  Publication 15-B.

3. Select Qualified Benefits Allowed Under Section 125

Only qualified benefits may be offered on a pre-tax basis. IRS sources include Publication 15-B and Publication 969.

• Group medical, dental, or vision coverage
• Health FSA (Flexible Spending Arrangement)
• Dependent Care Assistance Program (Section 129)
• Group-term life insurance (up to IRS exclusion limits)
• Adoption assistance (Section 137)
• HSA contributions with an HSA-eligible HDHP

Avoid including nonqualified benefits such as educational assistance, employee discounts, most transportation benefits, meals, lodging, or long-term care insurance, as these cannot be offered as choices under a cafeteria plan.

4. Apply IRS Limits for FSAs and Other Pre-tax Benefits

• Health FSA annual salary reduction limit (check latest IRS COLA updates):
  IRS Publication 15-B.
• Decide whether the plan includes:
  • A 2.5-month grace period, or
  • A carryover (up to the IRS annual maximum)

  These must appear in the written plan.

• Review rules for HSAs and FSAs in:
  Publication 969.

5. Establish Employee Elections and Mid-Year Change Procedures

• Employees must make elections before the start of the plan year (open enrollment).
• Elections are generally irrevocable for the plan year unless a permitted IRS change event occurs (marriage, birth, change in employment status, etc.).
• See IRS regulations under Treas. Reg. §1.125-4 for allowable election changes.

6. Implement Payroll Pre-tax Deductions Correctly

• Set up accurate pre-tax salary reductions for Section 125 benefits.
• Ensure proper W-2 reporting (e.g., Box 12 Code W for HSA contributions under Section 125).
• Review payroll rules in:
  Publication 15-B (Employer’s Tax Guide to Fringe Benefits).

7. Operate the Plan Consistently With IRS Rules

• Follow all written plan terms exactly. Deviations can invalidate the Section 125 tax exclusion.
• Apply FSA “use-it-or-lose-it” rules and ensure compliance with carryover / grace period rules.
• Perform required nondiscrimination testing each year to ensure the plan does not favor highly compensated employees.

8. Provide Employee Communications

• Distribute benefit summaries and enrollment instructions.
• Explain tax effects (lower taxable wages may affect credits or Social Security benefits).
• Provide details on qualified medical expenses using IRS resources such as:
  Publication 502 (for reference only — it does not govern FSA/HSA eligibility but helps employees understand medical expense categories).

9. Review and Update Annually

• Update plan terms and dollar limits annually based on IRS COLA announcements.
• Review compliance, correct any operational errors, and maintain required records.
• Visit AccountingPortal’s cafeteria plan resource for ongoing updates: Cafeteria Plan – Fringe Benefits.

M. Spik

Editor
25 years of experience managing tax, accounting, payroll, and employment-related information portals. Editor of Accounting Portal since 2011.
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