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Section 125 Cafeteria Plans

Reducing tax liability and allowing employees the freedom to manage health care costs is an attractive and important employee benefit. Cafeteria plans are employee benefit programs utilizing Section 125 of the Internal Revenue Code which allows employees to use funds set aside on a pre-tax basis to pay for certain qualified expenses from a menu of choices. Compensation that has been redirected into a cafeteria plan is exempt from Federal, State, or Social Security taxes thereby reducing the employee's taxable income and increasing their take home pay. Not only do employees save but most employers will find that the tax savings they experience offsets any administration costs to provide the plan. A cafeteria plan "menu" of options can include all three key levels of benefits or some combination of the three:

Premium Coverage

The most fundamental level of coverage in a cafeteria plan is the premium only benefit. This benefit allows health insurance premiums to be paid with pre-tax dollars and can be instituted alone in a premium only plan or used in combination with the following other levels of coverage.

Medical Flexible Spending Account

In addition to paying premiums with pre-tax dollars, an employer may also offer employees the ability to redirect a portion of their salary up to a pre-set limit into a flexible spending account. These pre-tax funds can be used to pay certain qualified expenses not covered by insurance including but not limited to insurance co-pays, insurance deductibles, vision expenses and dental expenses.

Dependant Care Flexible Spending Account

Another way employees can save on taxes and increase tax home pay is by paying for eligible dependant/childcare expenses with pre-tax dollar through the cafeteria plan.

There are other special considerations employers should take into account when establishing a cafeteria plan including:

  • Discrimination Testing and Highly Compensated employees
    Plans should be designed to ensure that all employees have similar contribution and participation opportunities under the provisions of the plan.
  • Participation Exceptions
    Special rules apply to owners, shareholders or partners in sole proprietorships, partnerships and S-Corporations with regard to their ability to participate in the plan.
  • Use it or Lose it
    Unused funds in the Medical Flexible Spending Account are to be forfeited back to the employer at the end of the plan year. Loss of funds can easily be avoided through employee education and communication.
  • Access to Funds
    When the funds are available to employees is often misunderstood by employers. Dependant Care expenses are only reimbursed as they are deducted from the employee's check and insurance premiums are pre-taxed as they are paid. However, the entire annual election into the Medical Flexible Spending Account is available to employees as of the first day of the plan year.
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