Internal Revenue Code 125 allows an employer to implement an employee benefit plan, which allows employees to select the benefit programs they prefer.
The plan offers two or more options and the employee chooses the option most appropriate for him or her from the “menu” of benefits available. It’s sort of like ordering lunch from the local deli – which is why the plan is referred to as a “cafeteria plan”!
Cafeteria plans, along with 401(k)s, are among the most popular employee benefit plans of the past decade. The tax benefits to the employer and employees far exceed the minimal required government reporting.
Cafeteria Plan Benefit Options
In general, the IRS allows the following benefits to be present in a Section 125 plan:
- Group-term life insurance (up to $50,000; amounts above that level of death benefit may be subject to Social Security and Medicare taxation)
- Accident and health plans
- Long- and short-term disability benefits
- Flexible spending accounts to save for health, medical, and childcare expenses
- CODA [401(k) plans]
- Dependent group life, accident, and health insurance coverages
Employee Tax Aspects
The plan essentially allows expenses that normally would be paid by the employee on an after-tax basis to be paid via salary reductions on a pretax basis. This allocated income will not be subjected to FICA or income taxes. The result is that taxable dollars have been converted to nontaxable dollars – thereby increasing the employee’s take-home pay.
Employer Tax Aspects
Generally, employer contributions to a plan are income tax deductible. In addition, contributions on behalf of the employees, if such contributions are not included in the employee’s income, are not subject to FICA (Social Security) or FUTA (Federal Unemployment Tax Act). This can result in significant savings to the company’s bottom line.
The employer must file an annual information return (IRS Form 5500) stating plan participation, cost and business type.
An important point for the employee to remember is that there can be no claim of any unused benefits or contributions from one plan year to the next. This is known as the “use it or lose it” rule.
Many employees steer clear of these plans because of this rule. You have to decide up front how much to put in the plan and if you don’t spend it all within a year, you forfeit the leftover amount.
Sounds risky – at least until you consider that the tax breaks are so powerful that even if you wind up forfeiting 20% of what you put into a plan, you’ll still come out ahead.
For example, let’s say you set aside $5,000 for
medical expenses in 2007 and wind up spending just $4,000. At face value, you’ve lost $1,000. But consider: If you’re in the 25% federal tax bracket and face a 5% state income tax as well as the 7.65% Social Security and Medicare tax, the $5,000 you put in the plan will save you more than $1,800 in taxes, leaving you $800 ahead. Put another way, you’d have to earn almost $6,300 to have $4,000 left over to pay those bills. Even if you forfeit $1,000, you still come out ahead. That’s why it’s wise to be aggressive in using flexible spending accounts.