What
is a Section 125 Cafeteria Plan? Your
employer may be offering this plan as part of your
overall compensation benefit package, but are you
taking advantage of it? In general, a Section 125
Cafeteria Plan, defined by Section 125 of the Internal
Revenue Code (originally enacted in 1978), allows
an employee to pay for anything from health insurance
premiums to dependent day care costs on a pre-tax
basis. It can provide a number of selections, including
medical, accident, disability, vision, dental, and
group term life insurance. The most common type offered
by employers today is called a Flexible Spending
Account (FSA), which provides employees with a pre-tax
method to pay for medical and/or dependent care expenses
that are not covered by their insurance.
Who
is eligible to participate in a Section 125 Cafeteria
Plan? The plan participant and a spouse or
other beneficiary of a plan participant may receive
benefits; however, only the plan participant (both
present and former employees) may make the election
of benefits. Self-employed individuals, sole proprietors,
partners in a partnership, and 2 percent or greater
shareholders in an S-corporation are not eligible to
participate in the plan.
What
qualifies as reimbursable medical expenses under a
Section 125 Cafeteria Plan? Reimbursable medical
expenses not paid for by an insurance company are “qualifying
expenses”
as defined in the Internal Revenue Code. Expenses can be
incurred by the employee, spouse, or dependent, and include,
but are not limited to, contacts and eyeglasses, lasik
eye surgery, dental exams and work, co-payments and deductibles,
doctors visits and hospital, and prescription and over-the-counter
drugs. Expenses that are not reimbursable include, but
are not limited to, controlled substances, cosmetic surgery,
hair transplants, household help, maternity clothes, vitamins
and supplements for general health, personal use items,
and weight-loss programs. You probably will want to place
a limit on medical expense deductions to minimize your
liability. You also must be careful to save all receipts
for items that you claim for reimbursement.
What
qualifies as reimbursable dependent care expenses? Reimbursable
dependent care expenses must be “qualifying”
as defined by the Internal Revenue Code and must meet the
following criteria: (1) expenses are for adults or children;
(2) children must be under age 13; (3) the expenses are
incurred to enable you and your spouse to be gainfully
employed; (4) the expenses are not payable to a dependent
of yours, under age 19, for caring for another dependent
of yours; (5) the limit is $5,000 if you are head of household
or file a joint return; and (6) your day care provider
must provide you with a tax identification number or social
security number.
Estimating
your qualifying reimbursable expenses. In
order to effectively participate in the FSA plan, an
employee must be able to estimate the costs that he
or she will incur during the upcoming plan year to
make the most out of the cost savings. The first thing
you must do is sit down and determine if you will be
paying for day care expenses and estimate those costs
per week or month, and also make sure that your situation
qualifies under the dependent care guidelines described
above. You should also take into consideration co-pays
for doctor visits for everyone in your family, any
probability that you or a family member will need new
eyeglasses or contact lenses, regular prescription
refills, and any other expenses such as dental work
you’ve been putting off because you couldn’t
afford it. By taking all of these events into consideration,
you should be able to figure how much to deduct from
your pay per period in order to satisfy these out-of-pocket
expenses for the year. Some employers provide a worksheet
in your benefits package to help you determine these
estimations.
What
are the tax savings? There are real tax savings
to the employee who participates in a Section 125 Cafeteria
Plan. For example, if you pay $2,000 for day care through
regular pre-tax contributions through an FSA rather
than making the payments personally out of earned income,
you will, of course, see a decrease in your take-home
pay. This decrease should be compared to the cost of
paying for those same day care costs in after-tax dollars.
The amount that you have deducted from your pay per
period in the plan is excluded from taxable income
for federal, Social Security and Medicare tax purposes.
It is also excluded from tax by most states other than
Pennsylvania. An individual fitting into this scenario
who is in the 15 percent tax bracket would save $300
in federal tax and $153 in Social Security and Medicare
tax in addition to any state tax. The reduction in
take-home pay would only be $1,547, less than the amount
the employee would pay in actual day care expenses
were he or she to pay for it personally!
What
are the downsides in participating in an FSA? All
employers should educate their staff about the pros
and cons of participating in such a plan. One thing
to remember is that redirecting wages which would be
otherwise taxable for Social Security purposes may
ultimately result in slightly lower government benefits
at retirement. Also, payments made for dependent care
are not eligible for the child care credit computation
on your federal tax return. Further, once you elect
to deduct a portion of your pay into the plan, the
election is not revocable except under specific circumstances,
such as changes in marital status, number of dependents,
or spouse’s employment. Additionally, any funds
unused by the end of the plan year are not refundable.
That is, if you elect to deduct a total of $200 from
your pay for the year and you find that you only had
$160 in reimbursable expenses, that remaining $40 will
not be returned to you and must be forfeited. Therefore,
a careful examination of your medical and/or dependent
care expenses should be made so that you do not deduct
too much or too little from your pay and you can make
the most out of the plan that best suits your individual
needs.
What
is a Premium-only Plan (POP)? There is another
type of Cafeteria Plan called a Premium-only Plan (POP).
A POP plan allows employees to deduct their share of
the premiums they pay for company-provided benefits
like health, dental, or life insurance from pre-tax
wages. While it does not offer employees any new benefits
per se, it does provide certain tax relief. Employees
pay less in taxes and therefore have a larger take-home
pay. On the flip side, employers save 7.65 percent
on Social Security and Medicare tax on the wages used
to pay these premiums.
How
does the employer benefit from offering their employees
cafeteria plans? With tax savings, of course.
As the taxable wages for Social Security and Medicare
are reduced, so are the taxes that must be paid by
the employer. In general, these taxes decrease by $765
for every $10,000 of benefits paid through the plan
on behalf of individuals who have total earnings less
than the Social Security threshold.
What
are the downsides to the employer for administering
such a plan? Cafeteria plans come with administrative
hassles often shared with the administration of retirement
plans. First, both the plan and the elections to participate
must be in writing. The plan must not discriminate
in favor of highly compensated employees and must be
tested for discrimination on an annual basis. Employers
must also file a tax return using Form 5500, and there
are strict penalties for delinquency for failure to
file the return. The tax return, however, is for informational
purposes only and results in no tax liability to the
employer. It is not as lengthy or complex nor does
it require the same detailed record keeping as those
returns required to be filed for retirement plans.
Once established, a written cafeteria plan may not
require amendment unless benefits are added.
Who
sets up Cafeteria Plans? A number of different
companies can set up Section 125 Cafeteria Plans, including
payroll services, insurance companies, third-party
administrators, and certified public accountants. The
annual costs can be anywhere from $300 to $600-plus
for the administration of a POP, and anywhere from
$800 to several thousand dollars for the administration
of an FSA. Third-Party administrators tend to cost
more than the others; however, they also are more likely
to waive set-up fees, depending on what other types
of benefit plans your company requires.
As
you can see, cafeteria plans are beneficial for both
the employee and the employer. If you find that you have
medical and/or dependent care expenses that exceed what
your insurance company will cover, deducting from your
pay on a pre-tax basis may be the best option for you
overall.
You
can find forms and publications on the IRS Web site at http://www.irs.gov/forms_pubs/pubs.html.
This includes Publication 502 Medical and Dental Expenses.
