A cafeteria plan allows employees to pay for some benefits with pretax dollars, so that the amount of taxable income to them is reduced. In its simplest form, a Premium-Only Plan (POP) allows employees to take employer-required medical insurance deductibles from their pretax income. This version of the cafeteria plan requires almost no effort to administer, and is essentially invisible to employees. The primary impact to them is that the amount of taxes taken out of their paychecks is slightly reduced.

A more comprehensive cafeteria plan includes a Flexible Spending Account (FSA), which allows employees to have money withheld from their pay on a pretax basis and stored in a fund, which they can draw down by being reimbursed for medical or dependent care expenses.

Example. Allison Schoening has a long-term medical condition that she knows will require a multitude of prescriptions over the plan year. She knows the prescription co-pays will cost her at least $800 during the year. Accordingly, at the beginning of the year, she elects to have a total of $800 deducted from her pay in equal installments over the course of the year. When she pays for a co-pay, she keeps the receipt and forwards it to the payroll department, which reimburses her for it from the funds that she has already had deducted from her pay.

By having funds withdrawn from their pay prior to the calculation of taxes, employees will not pay any taxes (e.g., income taxes, Social Security taxes, or Medicare taxes) on the withdrawn funds.

The cafeteria plans appears to be a sure-fire way to increase employee take-home pay. However, it has some built-in restrictions that, if not managed carefully, can result in a reduction in take-home pay. One issue is that employees are only allowed to choose the total amount of their annual cafeteria plan deductions at the beginning of the plan year; they cannot change it again until the plan year has concluded. This "lock-down" provision can only be altered when there have been changes in an employee's marital status, number of dependents (including adoptions) or the status of those dependents, residential address, or the employment status of the employee or a spouse or dependent. Furthermore, these changes must also result in a change in employee status in the underlying coverage before the amount of the cafeteria plan deduction can be altered.

Example. To continue the previous example, Allison Schoening's long-term medical condition clears up part-way through the year, and she can stop purchasing prescriptions. Consequently, she wants to reduce the amount of the cafeteria plan deductions being removed from her pay. She claims that there has been a change in her status because she changed residences midway through the year. This claim is denied by the cafeteria plan administrator, because the change in residence did not alter her eligibility for coverage under the terms of the underlying medical insurance plan.

The reason it is so important to closely match the amount of actual expenses incurred to the amount withheld under a cafeteria plan, is that if an employee does not submit a sufficient amount of qualified expenses to be reimbursed from the withheld funds, the remaining funds will be lost at the end of the plan year. Only those expenses billed to the employee prior to year-end can be reimbursed through the plan. When a reimbursement request is made, an employee must provide a receipt from the health care provider, and make a written statement that he or she has not received reimbursement for this expense from any other source. Consequently, it is best for employees to make a low estimate of the total amount of qualified expenses that they expect to incur by the end of the year, rather than have too much withheld and then lose the unused portion.

Example. Allison Schoening receives a periodic statement from the FSA plan administrator, informing her that she still has $250 of funds left in her cafeteria plan account with one month to go before the plan year-end. Accordingly, she accelerates the purchase of several prescriptions at the local pharmacy on the last day of the plan year, even though she will not need the medication for some time to come. Because this action is acceptable under the cafeteria plan rules, reimbursement of the late purchases from the fund are approved, and she does not lose any funds from her FSA account.

A problem for employers offering an FSA cafeteria plan is that employees may legally make claims against the fund that exceed the amount they have thus far contributed to the plan and then quit the company. When this happens, the business cannot seek recompense from the individual for the difference between the amount contributed into the fund and the amount paid out. Nor can a company alleviate this potential problem by forcing employees to accelerate the amount of their contributions beyond the preset amount.

Example. Mr. Adolph Armsbrucker contributes $100 per month into the company's FSA fund, which will result in a total contribution of $1,200 at the end of the year. However, he submits expenses to the plan administrator of $550 in February, for which he is reimbursed. He has only contributed $200 to the fund at this point, so the company is essentially supporting the fund for the difference between $550 in expenses and $200 in funding, or $350. Mr. Armsbrucker leaves the company at the end of February, leaving the company with this liability.

The favorable tax treatment accorded to participants in a cafeteria plan is only available if the plan passes several nondiscrimination tests. First, a plan must have the same eligibility requirements for all employees; this means plan participation cannot be offered solely to highly compensated employees, nor require more than three years employment with the company prior to participation in the plan. Second, all plan participants must have equal access to the same nontaxable benefits offered under the plan. Finally, no more than one-quarter of all nontaxable benefits provided under the plan can be given to key employees.