Section 125 “cafeteria plans” can help business owners and employees lower their tax bills. Under Section 125 of the Internal Revenue Code, workers are permitted to withhold a portion of their pre-tax salaries to pay for premium contributions to employer-sponsored insurance plans and to cover qualifying unreimbursed medical and dependent care expenses. Because Section 125 benefits are not subject to FICA or income taxes, cafeteria plans can help employees lower their taxable income, while reducing the payroll and workers’ compensation tax liabilities of their employers.

What’s on the Menu?

As the name suggests, employees who participate in a cafeteria plan are invited to choose from a menu of employer-sponsored benefits. In some cases, both the employer and the participating employees share in benefit costs. The company’s contribution may consist of an annual benefits allowance that employees can use to pay for benefits or take as salary. This system provides flexibility for workers, while helping employers gain greater control over their benefits expenditures.

The most basic cafeteria plan feature is the premium only plan (POP). Also known as premium conversion plans, POPs allow employees to withhold part of their pre-tax salary to fund their premium contributions to employer-sponsored insurance plans, including medical, dental, disability, accident, and group term life insurance. A POP is easy to set up and administer, and it does not require the employer to offer any new benefits.

Flexible Spending Accounts

A cafeteria plan may also include a flexible spending account (FSA), which provides employees with the opportunity to pay for dependent care and/or unreimbursed medical expenses using pre-tax dollars. To take advantage of the FSA option, an employee must estimate before the start of each tax year how much he or she will spend on medical or dependent care expenses, and commit to having a set amount withheld from each pay period to help cover these expenses. The agreed-upon sum is deducted from the employee’s paycheck before taxation and deposited in the individual’s FSA. Employees pay for qualifying expenses out-of-pocket and then submit a claim to the plan administrator for reimbursement. Unless an unanticipated change in family status occurs, employees are not permitted to change or cancel a Section 125 agreement during the tax year.

While nearly all taxpayers incur some health care costs not covered by insurance, most find that their unreimbursed medical expenses do not exceed the 7.5% of adjusted income floor that would allow them to qualify for a federal income tax deduction. But, by contributing to a medical FSA, employees get a tax break on these miscellaneous health care and dental expenses, which may include deductibles and co-payments, prescriptions, over-the-counter drugs, and orthodontia. The maximum amount that may be contributed to a medical FSA is $5,000 a year.

The dependent care FSA allows employees who pay for childcare or eldercare services to save money up-front, rather than waiting to claim a deduction or credit on their tax returns. Heads of household and married couples are permitted to withhold up to $5,000 annually of their pre-tax earnings to pay for dependent care services that enable them to work, look for work, or attend school full time. Qualified dependent care expenses generally include care for a child under the age of 13, as well as in-home or daycare services for a spouse or adult dependent incapable of self-care. Individual employees should, however, calculate whether they and their families would save more by paying for dependent care expenses through an FSA or by claiming the child and dependent care tax credit.

The biggest drawback associated with FSAs is the “use-it-or-lose-it” deadline imposed by the IRS. This rule stipulates that employees forfeit any funds left in their individual FSAs at the end of the year. The remaining balance is retained by the employer to offset administrative costs and to help pay for future benefits. This rule was modified in 2005 to permit cafeteria plan sponsors to extend the deadline for using the funds for up to 2½ months after the end of the year. There is also a grace period of 90 to 120 days during which employees may submit claims for expenses incurred during the coverage period.

Most business owners find that Section 125 cafeteria plans are simple to set up and administer. Because cafeteria plans encourage workers to take an active role in managing their benefits, companies can use these plans to increase awareness among workers of the value of their employer-provided benefits.


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