Many employers struggle with the challenge of providing an attractive compensation package at an affordable price. One tool available to meet this challenge is the Section 125 plan. Section 125 plans are also commonly referred to as cafeteria plans. While there are different types of Section 125 plans, each provides the opportunity to save money by reducing both the employer’s and employees’ tax liability. This article will outline for you the basics of offering a Section 125 plan
What is a Section 125 plan?
A Section 125 plan may be established pursuant to rules found in the Internal Revenue Code Section 125. This IRC provision provides an exception to what is generally called the “constructive receipt doctrine.” Under the constructive receipt doctrine, offering an employee a choice between cash and an employee benefit requires that the amount that could have been received be included in the employee’s gross income. A Section 125 plan allows employers to provide their employees with a choice between cash and certain qualified benefits without adverse tax consequences. Without a Section 125 plan, employee contributions can only be made with after tax dollars.
What are the different forms of Section 125 plans?
The three basic forms of Section 125 plans are:
- Premium Only Plan;
- Flexible Spending Accounts; and
- Full Cafeteria Plan.
What is a Premium Only Plan?
The Premium Only Plan is the most basic type of Section 125 plan and the most popular. A Premium Only Plan allows employees to pay their portion of insurance premiums with pre-tax dollars, which in turn reduces both the employer’s and employees’ tax liability. Benefits that are typically offered within a Premium Only Plan include: health, dental, vision, accidental death and dismemberment and group term life insurance.
Example: Employer Tax Savings
Thirty employees elect health insurance coverage. Under a Premium Only Plan, an employee’s monthly premium contribution of $150 per month is paid with pre-tax dollars.
Employer Tax Savings
Insurance Premiums $4,500
($150 X 30 employees)
Annual Salary Reduction $54,000
Employer Tax Rate* 9%
Employer Tax Savings $4,860
What is a Flexible Spending Account?
Under IRC Section 125, employees may make pre-tax contributions to a Flexible Spending Account. An employee may seek reimbursement from the Flexible Spending Account for expenses paid for child care, health plan deductibles and eligible medical expenses not otherwise covered under a health plan. A Flexible Spending Account allows an employee to increase his or her spendable income while also reducing the employer’s tax liability.
Example: Employee’s Spendable Income Increases
Without Section 125 Plan
Annual Salary $ 24,000
Federal Income Tax (15%) – 3,600
State Income Tax (3%) – 720
Social Security Tax (5.65%) – 1,356
Net Income $ 18,324
Health Insurance Premiums – 1,500
Out of Pocket Medical Expenses – 300
Child Care Expenses – 2,800
Remaining Spendable Income $ 13,724
With Section 125 Plan
Annual Salary $ 24,000
Health Insurance Premiums – $1,500
Out of Pocket Medical Expenses – $300
Child Care Expenses – $2,800
Net Income $19,400
Federal Income Tax (15%) – $2,910
State Income Tax (3%) – $582
Social Security Tax (5.65%) – $1,096
Remaining Spendable Income $14,812
The example above demonstrates an annual increase in spendable income if both a Premium Only Plan and Flexible Spending Account are utilized. While use of either a Premium Only Plan or Flexible Spending Account alone would produce a savings, the increase in spendable income would be less. The example reflects the temporary reduction in the employee portion of the Social Security tax for 2011 and 2012 from 7.65 percent to 5.65 percent.
What is a Full Cafeteria Plan?
Under a Full Cafeteria Plan, the employer makes a non-elective contribution for every eligible employee. The employees may spend the employer contribution to purchase any of the benefits offered within the Cafeteria Plan. In addition, the employee may contribute pre-tax dollars to purchase additional benefits beyond what he or she can purchase with the employer’s contribution.
Can an employer offer its employees a choice between cash and benefits?
Yes. If an employer has in place a Premium Only Plan or a Full Cafeteria Plan, it can offer its employees a cash-out option. For example, an employer may offer $500 to employees who do not elect benefits and can demonstrate that they have other coverage available through another group health plan. Because an employee that waives coverage in exchange for the $500 payment can later elect coverage following a qualifying event, it is suggested that the cash is paid in equal installments throughout the plan year.
What are the disadvantages of offering a Section 125 plan?
For an employee, the disadvantages of participating in a Section 125 plan include:
- An employee may not change his or her elections throughout the plan year unless he or she experiences a qualifying status change (for example, birth of child or marriage).
- Any unused funds remaining within a Flexible Spending Account at the end of the plan year and any applicable grace period are lost.
- While a Section 125 plan reduces the employee’s taxable income, it also may reduce other benefits. Benefits that are calculated using the employee’s income (for example, social security or retirement benefits) will in turn be reduced.
For an employer, the disadvantages of participating in a Section 125 plan include:
- While the employer reduces its tax liability, it is responsible for the cost, establishment and maintenance of the plan.
- Employers offering a health Flexible Spending Account bear some risk of loss. The uniform coverage rule requires that the full amount elected by the employee (minus any reimbursements already paid) be made available to the employee at any time during the plan year.
Example: An employee elects to contribute $3,600 to a Flexible Spending Account for the plan year. The employee contributes $300 each month. On January 15th, the employee submits a $3,600 receipt for his corrective eye surgery performed a week earlier. The employee is entitled to reimbursement of $3,600. Ten days later the employee terminates his employment. The employer is not entitled to recover from the employee the balance owed to the Flexible Spending Account for the plan year. For this reason, some employers limit the amount an employee can contribute to the Flexible Spending Account. Effective for 2013 plan years, the health care reform law limits employees’ annual salary reduction contributions to Flexible Spending Accounts to $2,500.
What special rules apply to small employers that want to sponsor Section 125 plans?
Effective in 2011, the health care reform law created Simple Cafeteria Plans to ease the small employer’s administrative burden of sponsoring a cafeteria plan. A Simple Cafeteria Plan is a cafeteria plan established by a small employer that meets certain contribution, eligibility, and participation requirements. By meeting these requirements, the cafeteria plan will be treated as satisfying the nondiscrimination rules applicable to cafeteria plans. For this purpose, a small employer is one that employed an average of 100 or fewer employees during either of the two preceding years.
Business Benefits Group welcomes the opportunity to help your organization examine its plan design(s) and make recommendations for improvement.