What is a cafeteria plan used for?

Some people refer to Section 125 plans as cafeteria plans. These plans allow employees to see significant savings on their income taxes by allowing them to use medical expenses to lower their taxable income. Employees enrolled in a cafeteria plan can also save money on FICA, unemployment tax and state and local taxes in some regions. The benefits aren’t solely for workers, as an employer who offers a Section 125 plan as part of a benefits package also receives some tax advantages.

The way this all works is that the IRS considers the money an employee pays into a Section 125 plan as pretax income. Whatever your employees decide to contribute is deducted from their income each week and not taxed, so they’re able to contribute to insurance premiums, health savings accounts, medical expenses and other qualifying costs tax-free. The way an employer benefits from this is in a reduction of tax liability for unemployment insurance, FICA, Social Security and more.

Employee options and plan types

Section 125 plans are sometimes called cafeteria plans because employees are offered multiple options and can enroll in whatever plans they prefer, similar to the numerous food choices at a cafeteria. Your business contributes a portion of the money invested in each plan and your employees determine how much they’d like to invest in the plans beyond those contributions. The tax advantages employees gain are one of the incentives that encourage them to contribute. You can offer these optional plans in addition to the traditional benefits package most workers have come to expect.

The IRS provides a benefit to employees through the Uniform Coverage Rule, which allows them to withdraw from their accounts at any point during the year, regardless of their contributions so far. For example, if an employee decides to contribute $100 per week into a cafeteria plan and incurs a medical expense of $1,500 early in the year, they can file a claim and receive the full amount. The employee can’t file a claim in excess of his or her yearly contribution amount, so you’d recoup the difference throughout the year.

Here are the types of Section 125 plans you can offer your staff:

Premium-only plans

POP plans allow your employees to save money by considering their insurance premiums as pretax income. You’re required to offer a group health insurance plan if you wish to include POP plans as part of your benefits package. Your business saves money because the amount of income used to calculate your contributions to FICA and unemployment insurance is reduced by the amount your employees contribute to their plans.

Employees’ premiums aren’t considered income, so they save money when they file their income taxes each year. They also benefit from reduced withholding because you calculate their regular taxes based on their reduced taxable income. Since many people enroll in work health plans and pay a portion of their earnings toward insurance anyway, this makes the contribution more attractive.

Flexible savings accounts

FSAs help employees plan for medical expenses and other out-of-pocket costs, such as prescriptions, daycare, elder care and unexpected medical treatments. Employees are asked to consider how much money they spend each year on preventive care, vision, dental, prescription medications, daycare costs and similar expenses. Based on an estimate of their regular health care expenses, they can contribute money from their paychecks into an FSA to help pay for these services when the need arises.

Since the money put into these accounts is considered pretax income, it can significantly reduce your workers’ taxable income at the end of the year. The best way to sell employees on the idea of an FSA is to remind them that the money they’re contributing is what they’re already paying for health care expenses. Keep in mind that you must offer an FSA with a group insurance plan.

Dependent care assistance program plans

A type of plan that many employers don’t offer their employees is the DCAP. Offering a DCAP plan can separate you from other employers and help with employee retention. There are also tax benefits for your business when you offer a DCAP.

Employees can contribute up to $5,000 each year toward their DCAP account, which can be used to cover expenses related to daycare, preschool, assisted living and home health care. Employees must meet certain qualifications to participate, but if they’re caring for young children or a family member who’s disabled, it can help them save a lot of money each year while still paying their normal out-of-pocket expenses.

To qualify, an employee must:

• Care for a child under age 13 and claim at least one child as a dependent on their tax return
• Claim a dependent who’s physically or mentally disabled
• Care for a spouse with a mental or physical disability

When employees contribute to a DCAP, it reduces your tax liability by lowering their taxable income. This means you’re required to contribute less to FICA and aren’t required to withhold as much tax from their check each pay period.

Benefits of section 125 plans

There are many advantages that your business and employees gain when you offer these plans:

• Tax flexibility: Cafeteria plans help employees maintain greater control over their taxable income and can be a wonderful tool for tax planning. Because employees can determine the amount they’d like to contribute, they can balance what they’re able to afford with the tax benefits they wish to receive.
• Tax savings: POP and FSA plans help employees save money on federal and state taxes while reducing their contributions to FICA and Medicare. They can do this while making money available to pay for out-of-pocket expenses they’re already responsible for.
• Reduced payroll tax liability: Businesses can lower their tax liability by paying less into payroll tax withholding, FICA and FUTA. These reductions are usually enough to justify the costs associated with setting the plans up because the Section 125 deductions are consistent and provide long-term benefits.

It’s up to you to determine whether the benefits of including cafeteria plans outweigh the costs. There are also considerations that employees need to make when deciding whether to enroll in one of these plans, which may make them hesitate. It’s important to inform your employees about how to get the greatest benefit before they enroll.

Disadvantages of section 125 plans

There are some drawbacks to offering these plans, and you’ll need to decide if they align with your business needs. The disadvantages of POP and FSA plans include:

• Setup fees: While you’re able to save money in the long term, you must consider whether your business is able to take on the upfront costs of offering Section 125 plans to your employees. It’s a good idea to consult a tax accountant before you make your decision to help you determine if your business can come out ahead.
• Upfront cost to employees: While employees may gain considerable tax savings at the end of the year, they’re contributing a portion of each pay into a plan. Some may need the money for other expenses and this may be a financial burden.
• Limited accessibility: Before enrollment, employees need to plan properly to avoid losing money. Whatever money isn’t used each year is lost, which means that if an employee over contributes, he or she could lose the money that wasn’t paid out in claims against the account.This is whythey must do their homework and assess their health care expenses accurately.

How to set up plans for your employees

The IRS provides an Employer’s Guide to Fringe Benefits that you can review to learn more about what qualifies as a benefit under Section 125 in the Internal Revenue Code. POP and FSA plans both qualify under the tax code, as long as you’re offering health insurance. You’ll need to review plans that can be offered in addition to your group health plan to see if it qualifies.

Many business owners and managers would prefer to have a third party handle the setup and maintenance of cafeteria plans so they can focus their energy on the core competencies of their business. You can often outsource your human resources functions to a company that integrates its HR technology with your current software. Such services ensure accuracy so your employees know that their withholding, FICA, FUTA and Section 125 benefit contributions are being handled properly.

Section 125 plans offer your employees an avenue to save money on their health care expenses, reduce their income taxes and plan ahead for their regular medical costs. They also help your company reduce its tax liability and save money when used as a long-term benefit. If you’re looking to entice new talent or retain your most valuable employees, you may want to consider offering these plans as part of your benefits package.