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However, with proper planning and good communication, the effect of any disadvantages can be greatly minimized. The plan documents must specify the plan year, and the plan year may be changed only for a valid business purpose, such as to align with the health care provider’s benefit year. This type of customized menu provides employees with more take-home pay and several additional benefits. The advantage of a cafeteria plan is that employees can choose what most makes sense for them. For example, a young employee with no health problems might opt to spend his or her cafeteria plan dollars on a minimal health plan. An employee with four family members might choose to spend their cafeteria dollars on a comprehensive health plan with a lot of coverage.
Employees may be reimbursed under this FSA for dependent care expenses that enable the employee to work. Dependent care FSA’s are not subject to the uniform reimbursement requirement. However, they are subject to the “use it or lose it” and “change in status” rules.
Can A Cafeteria Plan Make Advance Reimbursements For Medical Expenses?
Separate rules apply to employer contributions for HCEs and key employees. To spare small employers from nondiscrimination testing, and to encourage more small businesses to offer cafeteria plans, Congress amended IRC Section 125. This amendment — which took effect January 1, 2011 — permits small employers to adopt simple cafeteria plans.
With pre-tax benefits, you deduct the employee’s contribution before withholding taxes, reducing their taxable income. Typically with pre-tax deductions, the employee pays less in federal income and FICA taxes. Some states also allow a section 125 plan to reduce the amount an employee owes in state income taxes. Dramatically increasing health care costs have made this scenario a reality. Small employers might confuse that rule with the shorter eligibility testing rule under a simple cafeteria plan described above, which requires eligibility for employees who worked 1,000 hours in the preceding plan year.
In place of group health insurance, employers might offer a benefit allowance to employees to pay for plans. If the plan fails nondiscrimination testing, several consequences can ensue, including the key employee or HCE having to pay taxes on the benefits that failed the test — which would not have happened if the plan had passed. In addition, the employer may have to reissue Form W-2s, and may be subject to penalties and fines from the IRS. A key requirement of traditional cafeteria plans is that they must undergo annual nondiscrimination testing. The advantages of establishing a cafeteria plan are many for both employer and employee and significantly outweigh any perceived disadvantages. Employees can receive the benefits they want while at the same time lowering their and their employer’s tax liability and helping to control benefit costs.
Finally, unused funds remaining in an employee’s account at the end of the plan year may not be refunded to the employee or carried over to the next year. Detailed rules cover the types of changes in status relating to employment, marital status, dependents, etc., that may be permitted in the plan documents.
Certain employees are excluded from this requirement, such as employees under the age of 21 or those with less than 1 year of service. All eligible employees must be permitted to elect any benefit provided under the plan; any limitations must apply to all participants. To understand simple cafeteria plans, you must first know the fundamentals of cafeteria plans in general. Under IRS rules, the full amount elected for the plan year must be available to reimburse the employee’s medical expenses at all times during the year . In addition, the elected amount cannot be changed during the plan year unless the employee experiences a “change in status” (such as the birth or death of a dependent, marriage, divorce, etc.) and the plan permits the change.
What Is A Section 125 Plan?
A Cafeteria Plan is a reimbursement plan governed by IRS Section 125 which allows employees to contribute a certain amount of their gross income to a designated account or accounts before taxes are calculated. These accounts can be for insurance premiums, medical expenses and dependent daycare expenses, from which employees can be reimbursed throughout the plan year or claim period as they incur the expenses. Section 125 is a written plan that lets employees choose between two or more benefits, including qualified benefits (e.g., health insurance) and cash. Employees, their spouses, and their dependents can all benefit from section 125 plans. You must make contributions toward the benefits of each eligible employee who is not an HCE or key employee. Your contribution must be at least 2% of the employee’s compensation for the plan year, or 6% of the employee’s compensation for the plan year or twice the employee’s salary reductions — whichever is smaller.
HCEs or key employees receive greater access to benefits than non-HCEs or non-key employees under the plan. Key employees cannot elect more than 25% of the total benefits provided under the plan. (A key employee is an officer or owner of the company, as defined by the IRS.) Small employers often have owner-employees, and tend to have trouble passing the key employee test. Premium Only Plan is the process of taking after-tax employee contributions to their (employer-provided) group insurance and “converting” them to pre-tax contributions. This results in a tax savings for the employee as well as the employer (FICA and sometimes Workers’ Compensation). This is simply a bookkeeping transaction; no claim process is required as long as the proper documents have been executed to establish this benefit.
An FSA may be offered for dependent care assistance, adoption assistance, and medical care reimbursements. The benefits are subject to an annual maximum and are subject to an annual “use-or-lose” rule. The maximum amount of reimbursement which is reasonably available to a participant for such coverage must be less than 500 percent of the value of the coverage. In the case of an insured plan, the maximum amount reasonably available must be determined on the basis of the underlying coverage. An FSA cannot provide a cumulative benefit to the employee beyond the plan year. Section 125 plans allow employees to contribute pretax dollars into the plan. Contributions toward plans are not subject to federal, state, or social security taxes.
If an employee uses the full benefit of their plan and leaves the company before they have paid their yearly contribution, the employer incurs a loss. The individualized setup of cafeteria plans makes them more complex and time-consuming to administer. Employers must maintain constant communication with each employee about changes in the cost of benefits, their coverage, and their use of benefits. Essentially, a Section 125 cafeteria plan allows an employee to reduce the gross income amount used to calculate Federal, Social Security, and some State taxes. This amounts to a savings of between 25% and 40% of every dollar they contribute to the plan. The employer also realizes savings on FICA withholding tax for each participating employee. Generally, all employees with at least 1,000 hours of service during the preceding plan year must be allowed to participate in the Simple cafeteria plan.
Are you looking for a way to customize your benefits plan to meet the needs of your individual employees? This custom-selection option is an employee benefits plan that allows your employees to choose among a variety of offerings to create a benefits package that best meets their needs and those of their family. Your written plan must list and describe all the benefits you offer. Also, detail the contribution limits for each benefit, participation rules, employer contributions, the plan year, and any other necessary information. If you employed an average of 100 or fewer employees during either of the two previous years or if you expect to employ an average of 100 or fewer employees in the current year, you are eligible.
Cafeteria Plan Compliance
These allow the employee to contribute to these plans without incurring any tax penalties—a major benefit and advantage for an employee’s bottom line. A cafeteria plan gets its name from a cafeteria but has nothing to do with food. Just as individuals make food selections in a cafeteria, employees can choose the benefits of their choice before payroll taxes are calculated from a pool of options offered by their employers. These plans become more useful as diversity within workforces continues to grow and employees seek more personalized benefits that are tailored to their needs.
- Due to the uniqueness and complexities of Federal tax law, it is imperative to ensure a full understanding of the specific question presented, and to perform the requisite research to ensure a correct response is provided.
- A change in status event includes changes in the number of an employee’s dependents.
- A key requirement of traditional cafeteria plans is that they must undergo annual nondiscrimination testing.
- In these cases, the employee pays a part of the premium for his or her chosen benefits, so the cost to employers is lower.
- Section 125 of the Internal Revenue Code specifies that cafeteria plans are exempt from the calculation of gross income for federal income tax purposes.
Typically, cafeteria plans offer considerably more nontaxable benefits than taxable benefits, as nontaxable benefits are the main selling points. Successfully aiding the client in offering a useful, compliant Sec. 125 plan will be a win for the client — especially for its employees.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors.
Learn About Employee Perks And Fringe Benefits
Though some cafeteria plans offer an explicit choice of cash or benefits, most today are operated through a “salary redirection agreement”, which is a payroll deduction in all but name. Deductions under such agreements are often called pre-tax deductions. Salary redirection contributions are not actually or constructively received by the participant. Therefore, those contributions are not generally considered wages for federal income tax purposes, nor are they usually subject to Federal Insurance Contributions Act tax and Federal Unemployment Tax Act .
Advantages And Disadvantages Of Cafeteria Plans
Reasons for implementing a Section 125 plan are primarily for the tax savings advantages for the employer and employee. Both parties save on taxes and therefore increase their spendable income. Employees’ pretax contributions are not subject to federal, state, or social security taxes. Employers save on the employer portion of FICA, FUTA, and workers’ compensation insurance premiums. Cafeteria plans are governed by Section 125 of the Internal Revenue Code. The plan must offer employees a choice between at least one taxable benefit (e.g, cash) and one nontaxable benefit. If the plan provides only taxable benefits, then it is not a cafeteria plan.
In addition, those sums generally are not subject to FICA and FUTA. Cafeteria plans can offer health insurance to employees, their spouses and their dependents. The domestic partner and dependents in this case may not be participants in a cafeteria plan because they are not employees, but the plan may provide benefits to them. Premium conversion, the simplest type of cafeteria plan, permits employees to pay their share of premiums for health coverage, life insurance and other qualified benefits such as disability insurance on a pre-tax basis. To include salary reduction, in which the employee elects to decline to receive a portion of his or her pay and directs the employer to use the money to pay the employee’s contribution toward a specified benefit. Under the Code, the money, if used by the employer to pay premiums for a POP, is not constructively received by the employee and is not subject to tax. Employers who offer a POP are not required to offer employees any other form of cash, including cash in lieu of benefits, so employees who opt out of coverage receive no benefit, taxable or nontaxable.
Benefits Included In Section 125
The contributions are placed into an account the employee can use to pay for allowed expenses (e.g., premiums for health insurance, dependent care costs, medical supplies). Since no federal, state, or social security taxes are taken out and the dollars are not included as gross income, the employee saves anywhere from 27 percent to 50 percent on these purchases. Section 125 of the Internal Revenue Code specifies that cafeteria plans are exempt from the calculation of gross income for federal income tax purposes. However, some benefits—like group life insurance benefits that exceed $50,000 or adoption assistance benefits—require employers to withhold both Social Security and Medicare taxes. Salary reduction contributions are not actually or constructively received by the participant. Therefore, those contributions are not considered wages for federal income tax purposes.
Before this notice, reimbursements were permitted only for claims incurred during the plan year. Under the new ruling, an employee who participates in a Flexible Spending Account plan ending December 31 can still receive reimbursement for claims incurred through March 15 if the extended grace period is adopted by the employer. Benefits not included in a section 125 cafeteria plan typically do not reduce the tax liability for employees or employers. Instead, tax these deductions per the IRS instructions for the specific type of benefit you offer. Cafeteria Plans are one of the most popular employer benefits because they allow employees to save federal, state, and social security taxes on the benefits they choose. So, depending on your tax rate, that could add up to as much as 40% in tax savings, giving you more take home pay.
Save money without sacrificing features you need for your business. A highly compensated employee is an officer or shareholder owning more than 5% of the voting power.
For help writing your cafeteria plan, turn to a professional, like a business lawyer. They can help ensure your section 125 plan is accurate, legal, and understandable.
