Section 125 Cafeteria Plan – The Pros and Cons of a Section 125 Plan

Cafeteria plans are referred to as Section 125 because of the tax code where the law is spelled out, and are a way for employers to use pretax earnings to cover qualified medical expenses. These type of plans are appealing to employees because it offers them a greater level of choice in determining their own health care benefits (think choosing from food selections at a cafeteria). For business owners, a cafeteria plan can be a good way to reduce state taxes and payroll expenses.

What is Section 125 Cafeteria Plan?

A Section 125 Cafeteria Plan is a type of employee benefit plan that allows employees to choose between receiving cash compensation or selecting a variety of benefits, such as health insurance, retirement savings, and other fringe benefits, on a pre-tax basis. This allows employees to save money on taxes by paying for these benefits with pre-tax dollars.

Several working Americans have Section 125 Cafeteria Plan during their professional life. But many people fail to take advantage of the benefit options of cafeteria plans. If it is used the right way, a cafeteria plan can enhance your take-home amount without any kind of expenditure.

In the case of a cafeteria plan, an employer lets the eligible employees contribute some amount of their income to a specific account before the payroll taxes are calculated. The same account can be used for reimbursing the employee for some kinds of insurance premiums, dependent care, and vision expenses, dental insurance, and medical expenses throughout the claim period or the plan year.

With this plan, an employee can easily reduce the gross income amount from employee’s paycheck used for calculating Social Security, Federal, and some State tax amount. All of these can amount to a saving of 25%-40% for each tax free dollars you are contributing to the plan.

A qualified section 125 plan must give employees a choice between the taxable and nontaxable benefits option. Businesses that offer a cafeteria plan to their participating employees allow them to make their own choices about group health plans, health savings accounts, life insurance, dental and vision expenses, and long-term care.

Flexible spending accounts are one of the more popular benefit choices that fall under the tax savings umbrella of section 125.

There are qualified benefits on both sides when a company offers employees a cafeteria plan. Employees that have regular health care expenses can reap significant taxable benefits, especially from flexible spending accounts, since much of the premium only plan cost can be covered essentially tax-free.

For employers, a section 125 plan allows them to save money on both payroll and taxes through the tax-sheltered status of the taxable benefit.

What are the Benefits of Cafeteria Plans?

Section 124 cafeteria plans are one of the most underused and underrated plans that are available for small businesses out there. It allows employees to set aside a portion of their pre-tax basis salary for covering child-care or qualified medical expenses.

Here are some of the flexible benefits of the plan.

Pre-Tax Health Insurance Premiums Deduction

It is a premium-only plan. So, it enables employees to choose to withhold some amount of their pre-tax salary for paying their insurance premiums contribution for a majority of the employer-sponsored welfare and health benefit insurance plans.

With this health savings account, you can take advantage of favorable tax treatments for the advantages offered. Many companies have this set through the payroll provider. The Premium Only Plan (POP) is a simple kind of Section 125 insurance plan. It doesn’t need much maintenance once you set it up through the payroll.

Unreimbursed Medical Expenses Out of Pocket

A Flexible Spending Account (FSA) will let an employee fund some of their medical expense on a pre-tax mode through salary reduction for paying out the expenses incurred that aren’t covered by the insurance.

An average working employee in the USA spends over $100 every year on these kinds of benefits. If you avail FSA, your taxable income gets reduced and increases the percentage of the money you take home.

Flexible Account Spending for Dependent Care

Dependent care is an incredible qualified benefit for the employees who are paying for parent care or child care. Some employee fails to take advantage of this or might even be unaware of the considerable tax savings.

Employees might hold back an amount of $5000 every year of their pre-tax salary for the qualified expenses of dependent care. This includes expenses that they pay while they work, attend school full-time, and pre-tax salary.

Qualified dependent care expenses are-

  • Caring for a child under 13 years of age
  • Dependent incompetent of caring for himself
  • Summer day camps

Other than paying for dependent care using the pre-tax considered wages, you can save 20%-40% on child-care expenses.

How to Set Up a Section 125 Cafeteria Plan?

It is important to be compliant with the rules of Section 125 regulations. For that, you need a few documents. These are the employer and legal-specific aspects of the benefit plan of the employer that is required under both the Employee Retirement Income Security and Internal Revenue Code. A benefits attorney, broker, and third-party administrator should be able to help with offering these documents for Section 125 Cafeteria plan.

As multiple employee health benefits are covered by ERIA, they ask for a summary plan description. The main aim of this is to let the employees learn about the different aspects of the benefits plan which are being offered.

As per the law, the SPD has to be provided to all employees that are eligible. So, employers can create their own plan document with at least one qualified benefit. However, it is always better to talk to a health insurance attorney or broker who has a better idea about the compliance requirements.

The plan document of the employer should include-

  • Participation and eligibility plan participants
  • A description of the benefits provided by the plan
  • Details on how employer contributions are made
  • A provision that elections can be made during the time of open enrollment
  • The pre-tax contributions limit
  • The plan year

Based on the health benefits offered by paying the health insurance premiums, some added details might be required. The plan document of Section 125 Cafeteria created by the employer should state that just employees are eligible to be a part of the plan.

Spouses, employers, and dependents can’t contribute to this health plan at additional cost. But, a participating employee’s dependents and spouses might receive benefits through the plan until the time the participating employee is enrolled.

Who is Eligible for Section 125 Plans for Federal Income Tax Purposes?

Any employer that has employees subjected to paying income taxes in the US can offer a Section 125 Cafeteria plan. It includes S-corporations, C-corporations, governmental entities, partnerships, LLCs, or sole proprietorships. But not all types of companies will be able to offer certain benefits provided as per the carrier requirements.

Mistakes Employers Make with Section 125 Cafeteria Plans

Section 125 Cafeteria plan was started in 1979 as this is when the health insurance plan of the Internal Revenue Code takes effect. Since the introduction of the plan, it has become so popular that it is surprising to find an employer that doesn’t offer one. Even the smallest employers offer health insurance of Section 125 Cafeteria.

But like everything else, there are rules that should be followed for the health insurance premiums. And, where there are rules, mistakes can be made. Take a look at the mistakes to make sure that you don’t make them.

No Plan Document

It is not possible to have a Section 125 Cafeteria Plan if you do not have a plan document. When you give employees the choice between receiving less than the whole amount or receiving the entire amount of the pay, on a pre-tax basis, the share premiums for benefits, like the coverage under the group health plan, you should have a plan document.

In case you do not have on, it might imply that your business might be a problem. A plan document is very simple but is something that is essential for Section 125 Cafeteria Plans.

Plan Documents Not Being Prepared Carefully

One of the most common mistakes that employers tend to make is creating the plan document but not drafting it properly. Usually, these are canned documents, which a vendor has thrown in or an employer came across over the internet. The issue is if the document isn’t completed correctly, it fails to satisfy the plan document requirement of the health insurance, internal revenue service, and US Treasury regulations that accompany it.

Some of the examples of the documents not being drafted properly are given below-

  • Wrong Plan Year: The plan year that has been mentioned in the document has to comply with what you are doing. For instance, documents specifying that the plan year is the fiscal year starting 1st May of every year. In case that is what you are doing, it’s okay. However, sometimes, your business is just holding the annual enrollment period in the month of November and the new employee elects are going to be effective, then there has to be a good reason as to why the documents don’t specify that the document plan year and the calendar year is the same.
  • Wrong Kind of Entity: It is a problem when the plan document states that you are LLC when you are just a corporation that exist primarily in your state. That at least tells you that your document has not been prepared properly.
  • Specimen or Sample Documents: Your plan shouldn’t have words, such as Specimen or Sample at the top of the first page, on the signature page, on the footer, or anywhere else.

Letting Wrong People Participate in It

For the eligibility requirements in the cafeteria plan, a person has to be current, and in certain cases, the former employees of the employer. If someone is not an employer, they can’t participate in a cafeteria plan.

A member of an LLC becomes a part of the partnership, and over 2% of shareholders in the S corporations can enroll in the benefits, which an employer is offering. However, they can’t pay for the benefits with the help of pre-tax dollars using a 125 cafeteria plan.

Benefits are Excluded

In case your business lets its employees pay their share of health insurance premiums of the 125 cafeteria plans they have chosen using pre-tax dollars, ensure that those benefits have been identified in the 125 Cafeteria Plan. There are a lot of ways to do it.

However, often, plan documents are set up to that they simply refer to the spending accounts, such as DCAP and Health FSA. In case the document isn’t set up for referring to the group health plan, a group term life insurance, etc. the premium amount for the plans can’t be paid on the pre-tax basis from the cafeteria plan. It is an internal revenue service requirement and is quite basic. However, it can be overlooked.

Forgetting that the Health FSAs Comply with HIPAA Medical Privacy Rules

You can take Health FSA as a kind of designated account in a bank. People put money in it and then they have specific kinds of medical expenses, such as deductibles and unreimbursed copays, they can use the remaining funds in the health FSA to reimburse or to pay for the expenses.

This isn’t too far off the mark but the HIPAA medical privacy regulation takes a health FSA to be a kind of self-insured group health plan. It means that if your business is providing a Health FSA to the employees, it is subject to HIPAA.

For some employees, the Health FSA might be the only benefit they offer subject to a full scale of the HIPAA medical privacy regulations. In case your business is not providing one, do not wait until you have a complaint or a problem to check the HIPAA compliance.

What are the Drawbacks of Choosing a 125 Cafeteria Plan?

Even though this plan comes with a plethora of benefits, it is crucial to examine the possible drawbacks of the health plan before an employer offers the same.

Limited Time Frame

People who are putting their money into a Section 125 Plan should use the money during the plan year. If they don’t use the benefit provided for the particular year, they will lose the money. Proper planning is crucial from the standpoint of other employees.

Initial Setup Fees

An employer will have to pay an initial setup fee. The amount is minimized because of the considerable amount of savings present over the long term.

Employees Fund Expenses Upfront

Employees get a reimbursement for the expenses as it is a part of the flexible spending accounts. It means that expenses have to be paid from your pocket at first and then the employer reimburses employees.

Employees Cannot Change Election All Throughout the Year

Employees are not eligible for changing elections all throughout the years except for some qualifying events, such as considerable cost change under the health plan or the spouse of an employee dropping coverage in the time of their own open enrollment period.

Frequently Asked Questions

Can employees use HSA funds for non-medical expenses?

No, employees cannot use HSA funds for non-medical expenses without incurring penalties. HSA funds are intended for qualified medical expenses only, and using them for non-medical expenses can result in taxes and penalties.

How can employers make sure that their Section 125 plan is compliant with changing IRS regulations?

Employers can ensure their Section 125 plan remains compliant with changing IRS regulations by regularly reviewing and updating their plan documents to reflect any new requirements. They should also stay informed about any updates or changes to IRS regulations related to Section 125 plans and work with legal or tax professionals to ensure their plan remains in compliance. Additionally, employers should communicate any changes to employees and provide training on how to properly utilize the plan in accordance with IRS regulations. Regular audits of the plan can also help identify any potential compliance issues that need to be addressed.

Without a Section 125 plan in place, what would happen to an employee’s payroll contribution to HSA?

Without a section 125 plan in place, an employee’s payroll contribution to an HSA would be subject to federal income tax, Social Security tax, and Medicare tax. This means that the employee would effectively be paying more in taxes on their HSA contributions compared to if they were made through a section 125 plan, which allows for pre-tax contributions.

Final Thoughts

A strong employee benefit plan is an excellent way to retain and attract talent. When you choose the benefits of offerings, it is crucial to provide options, which will help the participants save some money as they strengthen their loyalty to the business.

With a Section 125 Plan or Cafeteria Plan, employees save money to be able to pay their dental, medical, or dependent-care expenses from the flexible spending account but on pretax payroll taxes. This can reduce their taxable income and the FICA taxes of the employer.

Call us today at the number at the top of the page if you’d like to learn more about the benefits of offering a section 125 cafeteria plan! We offer FREE cost estimates for business owners and employee groups, over the phone and through our online form. We’re happy to answer your questions!

Written by Todd Taylor

Todd Taylor

Todd Taylor oversees most of the marketing and client administration for the agency with help of an incredible team. Todd is a seasoned benefits insurance broker with over 35 years of industry experience. As the Founder and CEO of Taylor Benefits Insurance Agency, Inc., he provides strategic consultations and high-quality support to ensure his clients’ competitive position in the market.

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