Cafeteria Plans are employer sponsored employee benefit plans that allow employees to elect certain qualified benefits on a pre-tax basis. Authorized under Section 125 of the Internal Revenue Code, the IRS determines the benefits that are eligible for tax favored treatment and employers may offer some or all to their employees. Employees may choose cafeteria-style amongst a variety of options and coverage levels that best meet their individual and family needs. Qualified benefits under a cafeteria plan are not subject to FICA, FUTA, Medicare tax, or income tax withholding, thus employees and employers save money. A written plan document is required which describes all benefits and establishes rules for eligibility and elections consistent with the rules governing Section 125.
How it works:
A cafeteria plan allows participants to select qualified benefits on a pretax basis. Participants in a cafeteria plan must be permitted annually to choose among, at minimum, one taxable benefit (such as cash) and one qualified benefit. Once a choice is made, the benefit generally remains in effect for the duration of the plan year. Qualified benefits include:
- Accident and health benefits, including medical care flexible spending arrangements
- Adoption assistance
- Dependent care assistance
- Group-term life insurance coverage
- Health savings accounts, including distributions to pay long-term care services
During the open enrollment window, employees can select the specific benefits they desire for themselves and eligible dependents, at the available level of coverage they desire. Since benefit premiums or account contributions are not subject to federal or state taxes, take home pay increases. For every dollar spent on benefits, even a participant at the lower end of the tax brackets is expected to save twenty cents; at the upper end savings on every dollar spent may reach fifty cents. That is like receiving a 20% to 50% off coupon when purchasing qualified benefits. That dollar stretching means savings or the ability to purchase to more benefits.
A cafeteria plan is the only means available for an employer to offer employees a choice between taxable and nontaxable benefits without the choice causing the benefits to become taxable. Thus a cafeteria plan makes an excellent employer tool for recruitment and retention when used as part of a hidden paycheck. When a cafeteria plan is introduced employee satisfaction is heightened because participating employees experience a "raise" at no additional cost to the employer.
It is not just the employee who benefits with tax savings. For every premium or contribution dollar toward qualified benefits, Employer’s save in reduced FICA, FUTA, SUTA, and Workers' Compensation taxes. Generally these tax savings reduce or eliminate altogether the various costs associated with offering a cafeteria plan. Some employers use the tax savings toward premium reductions in subsequent years.
Maximize Savings by Keeping These Points in Mind:
Cafeteria plans can be a win-win for employers and employees alike, however, there are a few things to be aware of.
- Social Security: Since premiums or contributions toward qualified benefits are not included in taxable income, an employee may experience a lower Social Security income at retirement. However, the savings created by using a cafeteria plan are usually greater than the relatively minor dip experienced at retirement.
- Once made, enrollment choices are irrevocable for the entire plan year unless a qualified event occurs, including a change in family status.
- Participant Risk: Forfeiture Rule (Use it or lose it): Up to $500 in contributions remaining in a medical expense flexible spending arrangement at the end of the plan may rollover to the following year’s account. Any amount remaining in excess of this amount will be forfeited by the employee. Alternatively, an employer may offer a grace period which extends for up to two months and fifteen days the coverage period for incurring expenses. Participant risk may also be avoided by carefully estimating the amount to fund when enrolling.
- Employer Risk: Uniform Coverage Rule: Contributions to a medical flexible spending arrangement must be available to the participant uniformly throughout a plan year regardless if the account has sufficient funds. Any short fall during the plan year or when a participant terminates employment mid-year is covered by the employer. This is often offset by gains if/when a participant forfeits contributions.
- Dependent Care: Dependent care account expenses cannot be recovered through the childcare tax credit. But the savings from using the account is generally more than a participant recovers through other means. Employees should discuss how to best optimize this with a tax expert before enrolling.
- Employers must maintain strict paperwork, including a written plan document, filing proper tax returns and Forms 5500. Employers may not discriminate between regular and “highly compensated” employees when offering a cafeteria plan and must routinely test for such non-discrimination.
- There is an IRS permitted run-out period which extends period for filing claims incurred during the coverage period. Run out periods run the gamut from 60 to 180 days; on average 90 days is the usual time period.
This article is intended to provide accurate and authoritative information on the subject matter covered. It is distributed with the understanding that FBMC is not rendering professional or medical advice and assumes no liability in connection with its use.