Internal Revenue Code 125 allows an employer to implement an employee benefit plan which allows employees to select the benefit programs they prefer before taxes are calculated.

The plan offers the employee selections of insurance options (both health and life), health savings accounts, retirement plans, flexible spending accounts and other options the employee may choose from. Because of the "menu" of benefits available, the plan is referred to as a "Cafeteria Plan".

Cafeteria Plans, along with 401(k)'s, are among the most popular employee benefit plans of the past few decades. The tax benefits to the employer and employees far exceed the minimal required government reporting.

In general, the IRS allows the following benefits to be present in a Section 125 plan:

Basically, the plan allows expenses that normally would be paid by the employee on an after-tax basis to be paid via salary reductions on a pretax basis. This allocated income will not be subjected to FICA or income taxes. The result is that taxable dollars have been converted to nontaxable dollars – thereby increasing the employee's take-home pay.

Generally, employer contributions to a plan are income tax deductible. In addition, contributions on behalf of the employees, if such contributions are not included in the employee's income, are not subject to FICA (Social Security) or FUTA (Federal Unemployment Tax Act). This can result in significant savings to the company's bottom line.

The employer must file an annual information return (IRS Form 5500) stating plan participation, cost and business type.

An important point for the employee to remember is that there will often be no claim of any unused benefits or contributions from one plan year to the next. This is known as the "use-it-or-lose-it" rule.