Offering a great benefits package for employees helps businesses retain talent. But how can business owners save money when employer health insurance costs are soaring? One option that employers often overlook is a Section 125 plan (sometimes known as a “cafeteria plan”). Before you put together your benefits package, you should understand the definition of a Section 125 plan, when it can benefit your company and how you can start one.
A Section 125 plan allows employees to convert their taxable benefits, such as their salaries, into nontaxable benefits. Employees enrolled in Section 125 plans can reserve part of their pretax cash earnings to cover the costs of qualified benefits. A common example of a Section 125 plan is a flexible spending account (FSA), in which employees set aside pretax dollars from their paychecks to be used for qualifying medical expenses. The benefit of setting this money aside is that employees can save up to 30 percent on local, state and federal taxes.
As with most employee benefit plans, there is no obligation to participate in a Section 125 plan. Some employees may forego Section 125 plans in favor of standard cash wages. However, for many employees, setting aside money before taxes are taken out is preferable.
In a Section 125 plan, an employer sets aside a portion of an employee’s pretax wages to cover the costs of the plan’s qualified benefits. The employee never receives this money as part of their standard wages, so federal income tax is not taken on these earnings. Employers also benefit from setting aside wages for Section 125 use, since employer payroll taxes collected through Federal Insurance Contributions Act (FICA) and Federal Unemployment Tax Act (FUTA) are not taken on these funds.
Although taxes are not levied on these wages, you still must report them on your employees’ W-2 forms. For example, if you set aside $1,000 of an employee’s salary toward a Section 125 benefit during a plan year, you must report that amount on Box 10 of the employee’s Form W-2.
No matter the benefits you offer, you are responsible for managing the Section 125 plan. A professional employer organization (PEO) can help you perform these human resources (HR)-related tasks and administer benefits plans. The best HR software providers also offer tools for starting and managing Section 125 plans.
A PEO is a third-party organization that assumes co-liability for your workforce.
Here are some of the benefits of Section 125 plans:
Here are some of the drawbacks of Section 125 plans:
You don’t need to pay FICA or FUTA taxes on the portion of employee wages set aside for Section 125 plans.
All types of employers can open a Section 125 plan, including C corporations, S corporations, partnerships, limited liability companies and sole proprietors. Government entities can also offer these types of benefits to employees.
You should also know who on your team qualifies for cafeteria plan coverage. Typically, all employees who worked at least 1,000 hours for your company in the previous calendar year qualify for your current plan year. This difference may influence your decision to hire full-time or part-time employees. That said, you can exclude two employee groups from your coverage: employees under 21 and those who have worked for your company for less than a year.
No matter which benefits you choose to include in your plan, you must specify in writing what your Section 125 plan encompasses, how employees can qualify for these programs and how they can choose the benefits that are right for them. According to Section 125 of the Internal Revenue Code, cafeteria plans can cover the following qualified benefits:
Adoption assistance benefits, HSAs and DCAPs are traditionally offered as FSAs that reimburse employees for their qualified benefit expenses. FSAs typically include annual maximums and stipulate that funds don’t carry over from one plan year to the next.
Additionally, one exception exists regarding HSA coverage through cafeteria plans. This exception applies if your company offers health reimbursement arrangements (HRAs) through which your company covers your employees’ qualified medical expenses or insurance premiums. If this is the case and your employee has obtained insurance outside federal or state health insurance marketplaces or exchanges, the employee can use their cafeteria plan set-asides to cover non-HRA medical expenses and insurance premiums. This is the only case in which cafeteria plans can include HRAs.
Creating a Section 125 plan requires three fairly simple steps:
Once you begin offering Section 125 plans, you must remain vigilant about employment and anti-discrimination laws. Your company’s Section 125 plan must pass these three nondiscrimination tests:
Employees may lose favorable tax treatment if your company lapses in meeting these requirements. Even when your Section 125 plan is accidentally discriminatory, it includes remedies for the disadvantaged parties.
Mike Berner contributed to this article.