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Your company’s benefits package doesn’t have to be limited to bonuses and insurance. It can help your people make significant tax savings that benefit them financially in the long run.
Several plans allow you to accomplish this feat, including a Section 125 benefit plan. Also called “Cafeteria” plans, Sec 125 lets employees set pre-tax earnings aside in an account that they can withdraw from at a later date.
But before you rush into setting up one of these plans, you need to understand the nuts and bolts of how they work. This article answers the key questions you have about Section 125 plans so you can see if they’re right for your company’s employee benefits plan.
A Section 125 plan allows employees to convert their taxable benefits into nontaxable benefits. These taxable benefits include their salaries and any commissions or bonuses they receive. Think of these plans as special bank accounts attached to qualified benefits. The employee deposits money into the account, allowing them to reserve some of their pretax income. They can then use this money to pay for qualifying benefits as stated in the terms attached to the plan.
There are several types of Section 125 plans, with the most common being flexible spending accounts (FSA). Think of these accounts as Med 125 plans. Employees deposit pretax earnings into the account so they can withdraw them if they need to deal with medical expenses. The withdrawn money isn’t taxed when it’s used. Furthermore, the account allows the employee to save money for unforeseen emergencies.
So, we know that these plans offer tax benefits. But how extensive are these tax advantages?
The right Section 125 plan may help your employees to save up to 30% on the amount they pay in federal, state, and local taxes. Your employees have the option to decline participation in the plan. This flexibility allows your business to offer Section 125 plans as a benefit without having to enforce the plan for everybody.
Calling these plans “Cafeteria” plans is something of a misnomer. Despite the name, almost any business can create a Section 125 plan. These include partnerships, sole proprietors, limited liability companies, and both S and C corporations. Government entities can also create these types of plans for their employees. The plan must pass three nondiscrimination tests, which are detailed later in the article.
However, there are more stringent criteria to keep in mind for your employees. Generally speaking, an employee can only become a member of a Section 125 plan if they’ve worked for at least 1,000 hours during the previous calendar year. This amounts to approximately 19 hours per week, which means the benefits are usually open to both full and part-time employees. Additionally, employers have the option to exclude two groups of employees from their plans:
There are certain types of employees who can’t take part in the plans. These are typically people you work with who are classed as nonemployees, including:
Finally, employers have to create a written plan that defines any eligibility rules and the specific benefits the plan provides.
Tax calculations vary for every type of large group employee benefit plan. The 125 plans offer tax benefits for employees and employers.
On the employee side, you can deduct any contributions an employee makes before conducting tax calculations. This reduces the employee’s taxable income. Usually, employees pay less in FICA and federal income taxes as a result of participating in the plan. Your state may allow the employee to reduce their state income taxes, though this varies from state to state.
Employers benefit from their employees’ pretax contributions too. The contributions are made before you have to apply federal unemployment tax (FUTA) to paychecks. Though the tax stays at the same level of 6% for the first $7,000 the employee earns per year, contributions to a Section 125 plan reduce the amount of FUTA you pay on each check. Thus, you can spread FUTA costs throughout the year. Similar to how some states allow employees to reduce their state income taxes using Sec 125, some also allow employers to include contributions in their state unemployment tax calculations. Again, this varies depending on the state you operate in.
Beyond taxable benefits, such as salary and bonuses, there are several other types of benefits you can incorporate into these plans:
Generally speaking, a Section 125 plan can’t include any benefit that defers pay. The deferred payments are tax-effective vehicles in their own right. Beyond the previously mentioned Archer MSA and long-term care insurance exclusions, the following benefits can’t be included in Section 125 plans:
It’s a good idea to speak to a tax specialist before setting up a Section 125 benefit plan. They’ll be able to tell you what is Sec 125-eligible and what isn’t.
Employers generally don’t have to file anything with the Internal Revenue Service (IRS) or Department of Labor (DOL) to create a Section 125 plan. The main exception to this is if your company also offers a welfare benefit plan. In these cases, you may have to file a return for both plans using Form 5500 or Schedule F.
There are two main types of Section 125 plans you’re likely to create:
FSA accounts are typically offered alongside a group medical plan, making these Sec125 health options. Employees can use their pretax income to save for out-of-pocket medical and dependent care expenses, assuming they qualify under the plan’s criteria. In the case of dependents, these expenses can extend to elder care, prescriptions, and daycare. The money in an FSA can often go toward maintenance medications, dental work, and eye care.
POP stands for Premium Only Plan. These plans allow employees to save money on insurance premiums by using their pretax dollars to contribute to their costs. As such, you may consider creating a POP plan if your company offers group health insurance and you split the premium costs with your employees. POPs also reduce an employee’s taxable income.
You can only offer a POP if your company has a group medical plan. Generally speaking, participants have their premium payments taken before taxes are deducted from their paychecks under this plan.
The most obvious benefits of Section 125 plans lie in the tax advantages discussed earlier in the article. Both employers and employees can save money on federal, state, and local taxes. Employees benefit from being able to pay for out-of-pocket expenses using untaxed income.
On the employer’s side, the tax benefits often help to offset much of the initial plan startup cost. If operated over a long enough period, a Section 125 plan can save a business considerable amounts of money.
Though the tax benefits that come with these plans are attractive, there are several important drawbacks to consider before implementing them.
Employees operate within limited time frames when contributing to a Section 125 benefit plan. Any funds placed into the plan must be used within the plan year. If they’re not, the funds are lost completely. As such, employees must plan carefully when deciding how much to contribute. Placing more funds in an account than they’re likely going to need could lead to the employee losing money. This money is forfeited to the employer. Thankfully, a carryover provision exists that allows employees to extend up to $500 of their unused funds into the next year.
Section 125 plans come with high setup fees of between $200 and $600. Employers also need to update their plans yearly to account for new regulations, which costs money. POPs may come with an annual maintenance fee to build into your expenses.
If the Section 125 plan is attached to a health flexible spending account, employees have out-of-pocket costs to consider. They’ll need to pay expenses and provide proof that they’ve paid before they can claim a reimbursement.
Setting up a Section 125 benefit plan requires three actions:
The first two criteria are simple enough to meet as you’re told which documents are needed and how to inform employees. But the three nondiscrimination tests can be a barrier if you don’t understand what they are.
The nondiscrimination tests are designed to ensure that all employees receive equal benefits from your Section 125 plan. You must include every benefit offered via the plan to ensure this equality. The tests are divided into three parts.
Passing this test requires you to offer your plan to all eligible employees. This excludes the nonemployees mentioned in the “Who Can Use a Section 125 Plan?” part of this article, as well as non-residents and union employees.
Furthermore, you must prove that any requirements to enter the plan are the same for all employees. For example, you can’t have a rule that allows corporate employees to work for your company for less time than office or warehouse employees to enter the plan.
Again, equality is the focus of these tests. They ensure the plan doesn’t discriminate in favor of certain individuals in the company. A good example comes from plans that are tied to health benefits. If you offer to pay 100% of these benefits from some employees, you must make the same offer to all employees. Additional benefits are often tested on a percentage criterion to ensure that all employees receive the same benefits per their salaries.
Concentration tests are often the most difficult ones for small business owners to pass. They measure the pre-tax benefits offered to key employees against those offered to all other employees in your company. The test ensures that your key employees receive no more than 25% of the pre-tax benefits from the plan. As an example, if your company has five employees, three of which you class as key employees, this is an extremely difficult test to pass.
In addition to passing the nondiscrimination tests, you must work with a qualified third-party administrator to oversee the plan. These professionals keep your documentation updated and help you meet compliance requirements.
Third-party administrators generally conduct the following tasks:
With its raft of tax benefits, a Section 125 plan makes a great addition to your company’s benefits package. In addition to helping the business save money, these plans allow your people to use pretax contributions to cover pretax expenses. This amounts to an effective pay rise because employees can reduce their taxable income while retaining the ability to use the money they’ve earned.
Better yet, compliance is fairly simple to achieve with the advice of an appropriate professional. Plus, the fact that the plan isn’t mandatory for all employees means your team members can choose whether they want to participate.
At Taylor Benefits Insurance Agency, our team can help you to integrate a Section 125 plan into your company’s benefits package. To find out how give us a call at 800-903-6066 or contact us online to discuss your options.
Todd Taylor with Taylor Benefits gives our small business the kind of personal service we need. Insurance benefits are important to our employees and Todd helps us find a balance between benefits and value. Todd responds immediately to my phone calls & e-mails. He has even gotten in touch with me on a Sunday when we were in need of coverage answers immediately. We are very pleased with the hands-on service Todd and his staff provide.”
-Ken and Linda Orvick, Orvick Management Group, Inc.
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