Section 125 Cafeteria Plan Payroll: 2026 Limits and Coding

A section 125 cafeteria plan is a separate written plan under Internal Revenue Code section 125 that lets an employee choose, before the plan year starts, between at least one taxable benefit, such as cash, and one qualified benefit on a pretax basis. It is the only mechanism that lets an employer offer that choice without the qualified benefit itself becoming taxable income the moment the employee is allowed to pick it.

For payroll, everything downstream depends on that one election. Salary-reduction contributions made under a valid section 125 plan are not wages for federal income tax purposes, and are generally excluded from Social Security, Medicare and federal unemployment tax. Getting the deduction coded correctly, and catching the handful of benefits inside a cafeteria plan that do not get that exclusion, is where a 25 to 100 employee payroll department most often gets tripped up.

How a Section 125 Election Changes What Payroll Withholds

The written plan document is what makes the pretax treatment legal in the first place. Without it, an employer offering employees a choice between cash and a benefit makes the entire benefit taxable, because the IRS treats the mere availability of cash as taxable under the doctrine of constructive receipt. A compliant section 125 plan is the single exception that Congress carved out to that rule.

Once the plan is in place and an employee elects a qualified benefit, the salary-reduction amount comes out of gross pay before federal income tax is calculated, and is generally excluded from Federal Insurance Contributions Act tax and Federal Unemployment Tax Act tax under IRC 3121(a)(5)(G) and 3306(b)(5)(G). That exclusion is what payroll is actually coding for on every run, on a health FSA election, a dependent care election, or a premium-only election, the deduction has to be set up to bypass those tax calculations, not just to reduce net pay. The full mechanics are laid out in the IRS FAQs for government entities on cafeteria plans.

The 2026 Pretax Limits Payroll Has to Enforce

Two dollar limits govern the most common cafeteria plan elections in 2026, and a payroll system that does not stop a deduction at the right number creates a correction later.

The $3,400 health FSA figure and the $680 carryover cap both come from Rev. Proc. 2025-32, section 3.15. The dependent care number is a statutory limit rather than an inflation-adjusted one, and it has not moved with the FSA figure, which is exactly why the two get confused on a payroll build that treats every cafeteria plan election the same way.

Where the Pretax Exclusion Does Not Apply

Not every benefit run through a cafeteria plan gets the same tax treatment, and this is the part of section 125 payroll coding with the most exposure. Group-term life insurance coverage over $50,000, even when the employee elects it inside a cafeteria plan, is still subject to Social Security and Medicare tax on the imputed cost of the excess coverage. Adoption assistance offered through the plan is subject to Social Security, Medicare and FUTA tax, even though it is otherwise treated as a qualified benefit. And any cash an employee takes instead of a qualified benefit is fully taxable wages, with no pretax treatment at all, because the constructive receipt problem the plan exists to avoid is exactly what happened.

A payroll deduction code that applies a blanket pretax exemption to every cafeteria plan line item will miss all three of these, and the exposure lands as unremitted Social Security, Medicare and FUTA tax that has to be corrected after the fact, with amended returns and corrected W-2s, rather than a clean number caught on the original run.

What a 25 to 100 Employee Employer Gets Wrong on Cafeteria Plan Payroll

• Treating every cafeteria plan benefit as automatically FICA exempt. Group-term life over $50,000 and adoption assistance both stay subject to Social Security and Medicare tax, and adoption assistance also stays subject to FUTA.
• Reimbursing FSA claims before expenses are substantiated. A cafeteria plan cannot advance reimbursement ahead of a documented expense, no matter how routine the claim looks.
• Assuming the cafeteria plan itself needs a Form 5500. It typically does not. The mistake runs the other way too, assuming no Form 5500 is ever needed, when the underlying welfare benefit plan the cafeteria plan offers may still require one under Department of Labor rules.
• Letting an FSA election run past $3,400 or a carryover run past $680. Both are hard 2026 limits, not targets, and an uncapped payroll deduction creates an excess contribution to unwind later.
• Leaving dependent care overages in Box 10. Anything above the $5,000 exclusion, $2,500 if married filing separately, belongs in Boxes 1, 3 and 5 as wages, not in Box 10 with the rest of the excludable amount.

Coding a section 125 deduction correctly across every one of these exceptions, on every payroll run, is exactly what BEG managed payroll handles as part of the standard service.

BEG's role in a section 125 cafeteria plan sits entirely in the mechanics of the payroll run: setting up the pretax deduction codes so section 125 amounts come out before federal income tax, FICA and FUTA are calculated, stopping FSA elections once an employee hits the annual limit, and reporting the correct Box 10 and Box 12 figures on the W-2. Writing the plan document, running nondiscrimination testing, designing the plan and any Form 5500 filing stay with the client's benefits counsel or third-party administrator. FSA and HSA coordination live inside BEG's optional Managed Benefits add-on at $10 PEPM, not the base payroll fee.

What This Means for Payroll Operations

• Cap every 2026 election at the exact limit. $3,400 for the health FSA, $680 for carryover if the plan allows it, and $5,000 ($2,500 married filing separately) for dependent care.
• Flag the three exceptions on every run. Group-term life over $50,000, adoption assistance, and any cash taken instead of a benefit all stay subject to some or all of FICA and FUTA.
• Never reimburse before substantiation. Advance reimbursement ahead of a documented expense is not permitted under a cafeteria plan.
• Report Box 10 and Box 12 correctly on the W-2. Dependent care totals and any excess wages need to land in the right boxes, not be combined or left out.
• Confirm the Form 5500 question with counsel, not payroll. Whether the underlying welfare benefit plan needs a filing is a plan-design question, not a payroll one.

Frequently Asked Questions

Sources: IRS, FAQs for Government Entities Regarding Cafeteria Plans; IRS Rev. Proc. 2025-32. This is general payroll and tax information, not legal or tax advice.