5.2 Retirement, Health, and Cafeteria Plan Payroll Effects
Key Takeaways
- Section 125 elections usually reduce federal income tax wages and often FICA wages, but payroll must follow the plan document and the specific benefit tax rule.
- Traditional 401(k) deferrals generally reduce federal income tax wages but remain subject to Social Security and Medicare taxes; Roth deferrals remain taxable for federal income tax and FICA.
- For 2026, IRS sources list a $3,400 health FSA salary-reduction limit, HSA contribution limits of $4,400 self-only and $8,750 family, and a $24,500 basic elective deferral limit for common salary-deferral plans.
- Payroll’s core job is not plan design; it is accurate eligibility dates, election coding, limit monitoring, taxable wage boxes, employer-match treatment, and reconciliation.
Benefit Elections Change Wage Bases
Retirement, health, and cafeteria-plan questions are payroll calculation questions disguised as benefits questions. The employee sees a medical plan, a health flexible spending arrangement, a health savings account, a 401(k) deferral, or a dependent care election. Payroll sees taxable wage bases, deduction timing, employer contributions, limits, arrears, refunds, W-2 boxes, and reconciliation to carriers or trustees. For FPC study, the key is not memorizing every plan-design rule. It is knowing how a benefit changes gross-to-net pay and employment tax reporting.
A cafeteria plan under section 125 is a written plan that lets employees choose between taxable cash and certain qualified benefits on a pre-tax basis. Publication 15-B lists qualified benefits such as accident and health benefits, adoption assistance, dependent care assistance, group-term life coverage, and health savings accounts.
It also lists benefits that cannot be offered through a cafeteria plan, including de minimis benefits, working-condition benefits, qualified transportation benefits, employee discounts, lodging, meals, and retirement planning services. Payroll should therefore ask two questions: is the benefit allowed under the cafeteria plan, and does the employee have a valid election in force for the payroll date?
Common Payroll Effects
| Benefit or election | Federal income tax wages | Social Security and Medicare wages | FPC note |
|---|---|---|---|
| Section 125 medical, dental, vision, or health FSA salary reduction | Usually reduced | Often reduced | Follow the written plan and eligibility date. |
| Traditional 401(k) elective deferral | Usually reduced | Generally not reduced | The deferral remains FICA wages. |
| Roth 401(k) elective deferral | Not reduced | Not reduced | Roth is after-tax for payroll withholding. |
| Employer 401(k) match or nonelective contribution | Usually not wages | Usually not wages | Do not subtract a match from employee net pay. |
| Employer HSA contribution for eligible employee | Excluded up to limits | Excluded up to limits | Eligibility is determined monthly. |
| Excess or ineligible contribution | Taxable correction issue | Depends on rule | Escalate before year-end reporting. |
Health, FSA, And HSA Limits
For plan years beginning in 2026, Publication 15-B says a health FSA salary-reduction contribution cannot exceed $3,400. The publication is strict: a cafeteria plan that fails to limit health FSA contributions to the dollar limit is not a cafeteria plan, and all benefits under the plan become includible in the employee's gross income. That is a high-severity payroll compliance trap. A payroll system should reject over-limit elections, monitor midyear changes, and coordinate corrections with benefits administration.
Health savings accounts have their own rules. Publication 15-B states that employer HSA contributions for a qualified individual are exempt from federal income tax withholding, Social Security, Medicare, and FUTA up to the statutory limits if the employer reasonably believes the employee can exclude the benefit.
For 2026, the listed HSA limits are $4,400 for self-only high deductible health plan coverage and $8,750 for family coverage, with an additional $1,000 for a qualified individual age 55 or older. Payroll should remember that the HSA belongs to the employee, employer contributions cannot be withdrawn by the employer, and no contributions can be made after Medicare Part A or B enrollment.
The FPC exam may not require every annual dollar limit for every window, especially because PayrollOrg assigns law dates by testing period. Still, the current-source workflow matters: use the law date tied to the candidate's exam window, then apply the same payroll logic. Limits are facts to verify; wage-base treatment is the durable exam skill.
Retirement Deferrals
Retirement deductions are a classic gross-to-net trap. IRS retirement guidance states that pre-tax employee elective salary deferrals are generally subject to Social Security and Medicare but not federal income tax withholding. Roth deferrals are subject to both federal income tax withholding and FICA.
Employer matching and nonelective contributions generally are not subject to either. For 2026, IRS contribution guidance lists a $24,500 basic elective deferral limit for 401(k), 403(b), SARSEP, and governmental 457(b) plans, with catch-up contributions allowed for eligible employees; current IRS news also notes a higher catch-up limit for ages 60 through 63 in applicable plans.
A payroll example shows the wage-base difference. An employee earns $2,000 and elects a $150 traditional 401(k) deferral plus $120 in pre-tax medical premiums under a valid section 125 plan. Federal income tax wages generally start at $1,730: $2,000 minus both deductions. Social Security and Medicare wages generally start at $1,880: $2,000 minus the section 125 medical deduction, but not the traditional 401(k) deferral. If the $150 were Roth, federal income tax wages would generally be $1,880. If the employer also contributes a $60 match, that $60 is not a payroll deduction from the employee and is not added to current wage withholding.
Controls Payroll Owns
Payroll should maintain effective dates, election amounts, benefit codes, plan-year maximums, arrears handling, termination rules, refund rules, and W-2 mapping. Form W-2 reporting commonly distinguishes boxes 1, 3, and 5 because benefit elections may reduce one box but not another. Retirement deferrals often appear in box 12 with the appropriate code, while employer-sponsored health coverage cost may be reported with code DD when applicable. Dependent care assistance is reported separately because taxable and nontaxable amounts can diverge.
FPC scenarios often ask what went wrong. If a medical election starts before eligibility, payroll understated wages. If a traditional 401(k) deferral reduced Social Security wages, payroll underwithheld FICA. If an employer match was deducted from net pay, payroll treated employer money as employee money.
If a health FSA election exceeds the annual limit, the issue is not only an employee deduction problem; it can threaten cafeteria-plan tax treatment. The professional answer is to stop the bad code, correct wages and taxes, document the plan source, reconcile payroll to benefit invoices, and escalate plan-compliance issues to the responsible benefits or tax adviser.
An employee elects a traditional pre-tax 401(k) deferral. What is the usual federal payroll effect?
A 2026 health FSA election exceeds the IRS salary-reduction limit under a cafeteria plan. What is the best payroll control response?
Which amount is generally not an employee payroll deduction from net pay?