Cafeteria Plans Section 125
One of the most underrated and underused
employee benefits available for small businesses today is
outlined in section 125 of the U.S. tax code. A section 125 or
"cafeteria" plan allows employees to withhold a portion of their
pre-tax salary to cover certain medical or child-care expenses. Because these
benefits are free from federal and state income taxes, an employee's taxable income
is reduced, which increases the percentage of their take-home pay. And because
the pre-tax benefits aren't subject to federal social security withholding
taxes, employers win by not having to pay FICA--or workers' comp premiums--on
those dollars.
With so many advantages, why is the plan
underused? The most likely reason is that these plans don't generate a lot of
profit for benefit administration companies, and with little profits to earn, only minimal advertising is being done. That means
many people are unaware the plan even exists. But utilizing the tax code for your business can be an
incredible way to enhance your employee benefits package,
while simultaneously boosting your margins.
1. Pre-tax health insurance premium
deductions, also known as a Premium Only Plan (POP). POP plans allow employees to elect to
withhold a portion of their pre-tax salary to pay for their premium
contribution for most employer-sponsored health and welfare benefit plans. The
plan offers a simple way to obtain favorable tax treatment for benefits already
offered. Most companies currently have this set up through their payroll
provider. A POP plan is the simplest type of Section 125 plan and requires
little maintenance once it's been set up through your payroll.
2. Out-of-pocket unreimbursed medical
expenses, also known as flexible spending accounts (FSAs). An FSA allows an employee to fund certain
medical expenses on a pre-taxed basis through salary reduction to pay for
out-of-pocket expenses that aren't covered by insurance (for example, annual
deductibles, office co-payments, prescriptions, over-the-counter drugs and
orthodontia). The average working employee in America spends
more than $1,000 annually on these types of benefits. By participating in a
FSA, an employee's taxable income is reduced, which increases the percentage of
pay they take home.
3. Dependent care flexible spending accounts. The dependent care FSA is an attractive
benefit for employees who pay for child-care or long-term care for their
parents. Many employees don't take advantage of this benefit and may be unaware
of the significant tax savings. Employees may hold back as much as $5,000
annually of their pre-tax salary for dependent care expenses, which include
expenses they pay while they work, look for work or attend school full time.
Qualified dependent care expenses may include--but are not limited to--the care
of a child under the age of 13, long-term care for parents, care
for a disabled spouse or a dependent incapable of caring for himself, and
summer day camps. In addition, by paying for dependent care with pre-tax
dollars, your employees can save approximately 20 to 40 percent on their
child-care expenses.
The best part about the Section 125 plan is
that most of your employees are already paying for these expenses out of their
own pockets with after-tax dollars. Cafeteria plans offer them a remarkable way
to save money they're already spending.
Here's how it works:
·
Prior to the beginning
of each plan year, an employee estimates how much they'll spend in
out-of-pocket medical expenses and/or dependent care expenses during the course
of their plan year. (The plan year would be defined in their summary plan
description).
·
Note: It's important
for employees not to overestimate their annual election amounts, as the FSA is
a "use it or lose it" benefit and they'll forfeit any unused balance
remaining in the account at the end of each plan year. (There's a grace period
for which an employee can file claims for each plan year.) If there's a FSA
surplus at the end of the plan year, the remaining balance shall be retained by
the employer to offset administrative expenses or future employee benefit
costs.
·
This amount is then
deducted over the course of the plan year from their paychecks prior to being
taxed and is deposited into their flexible spending account. On or after the
first day of the plan year, an employee is restricted from changing or revoking
the section 125 agreement with respect to the pre-tax premiums until the plan
year has ended unless a "change in family status" occurs (as defined
under the federal tax code) and the change is consistent with the "change
in family status."
·
Your employees would
pay their out-of-pocket expenses upfront and then submit a claim and
documentation to the plan administrator. A reimbursement would then be made
from their own account with pre-taxed dollars and sent
to them in the form of a check.
So what are the benefits to you as the
employer?
·
Every dollar ran
through the 125 plan reduces an employer's payroll. Therefore, you don't have
to pay FICA or workers' comp premiums on those
dollars. In many cases, this savings can add up to as much as 20 percent of
every dollar being passed through the plan.
·
Implementing a
cafeteria plan can "soften the blow" of premium increases to
employees. For example, let's say a company's medical premiums are raised 10
percent for the year--a-not-unheard-of amount. Let's assume that 10 percent
increase takes the premium for one of the company's employees, including their
dependents, from $800 to $880 per year. Let's also assume the employer pays for
100 percent of the employee-only rate, which is $200 in this example, leaving
the employee responsible for the cost of his or her dependents ($600). With a
10 percent increase on the portion the employee pays, the employee is now
paying an additional $60. If these additional costs are run through a POP plan,
an employee in the 25 percent tax bracket would have an increase of just $45,
rather than $60.
·
Employees can use tax
savings to invest in retirement plans. By using
an FSA, your employees can save money on their everyday expenses, thus freeing
up more of their income to be allocated to their 401(k) account, which
increases participation.
And what are the benefits to your employees?
·
Participating in a
cafeteria plan reduces an employee's taxable salary and increases the
percentage of their take-home pay, thus increasing their spendable income.
·
They receive a greater
deduction on dependent care expenses than what's offered by a traditional tax
credit at the end of year.
·
There's less of an
impact on employees from insurance increases, such as premiums, co-pays,
deductibles and so on. One of the most common ways for employers to keep
benefit costs down is to simply lower the benefit levels of their plan
offering. While this save you money on your premiums,
your employees are then faced with greater deductibles, higher co-pays, higher
prescription amounts and so on. Through the use of an FSA, employees can set
aside money to cover these increased amounts, which lessens their out-of-pocket
costs because they're setting aside tax-free dollars.
There are several administrative procedures
that must be met to comply with Section 125 code legal requirements.
1. A plan document must be established. This document outlines specific details, such
as a description of the employee benefits that are covered through the plan,
participation rules, annual limits, election procedures, eligibility
and employer contribution. It also defines the plan year.
2. A summary plan description (SPD) must be
distributed to all participants. Section 104(b) of the Employee Retirement Income Securities Act
of 1974 (ERISA), the basic law designed to protect the rights of participants
and beneficiaries of employee benefit plans, requires that an SPD must be
distributed to all participants no more than 90 days after an employee becomes
a participant or within 120 days of the plan becoming subject to ERISA. A
participant's beneficiary must also receive the summary plan description within
90 days after becoming eligible for benefits. The SPD summarizes specific
details of the plan, claim filing procedures, and information concerning plan
sponsorship and administration. In addition to distributing it to your
employees and their beneficiaries, you must also file it with the Department of
Labor within 120 days of the plan's effective date.
3. There's ongoing compliance that must be
attended to. The laws are
constantly changing and being updated. Federal legislation requires that
section 125 plans can't discriminate as to eligibility and benefits being
provided. Failure to meet the nondiscrimination requirements would eliminate
the tax-free status of the benefits provided to the highly compensated and/or the
key employees.
One of the best benefits for business owners
is that cafeteria plans cost very little to set up and maintain. For most
employers, the cost of implementing the plan is recovered through tax savings
during the first year--you might even begin saving money as early as the month
following the installation of a POP plan.
So what are you waiting for?