Full §125 Cafeteria Plan

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A Cafeteria Plan (includes Premium Only Plans and Flexible Spending Accounts) is an employee benefits program designed to take advantage of Section 125 of the Internal Revenue Code. A Cafeteria Plan allows employees to pay certain qualified expenses (such as health insurance premiums) on a pre-tax basis, thereby reducing their total taxable income and increasing their spendable/take-home income. Funds set aside in Flexible Spending Accounts (FSAs) are not subject to federal, state, or Social Security taxes. On average, employees save from $.25 to $.49 for EVERY dollar they contribute to the FSA.

 §125 Premium Only Plan (POP)

Employers may deduct the employee’s portion of the company-sponsored insurance premium directly from said employee’s paycheck before taxes are deducted.

Flexible Spending Account (FSA)

In an FSA, employees may set aside on a pre-tax basis a pre-established amount of money per plan year. The employee can use the funds in the FSA to pay for eligible medical, dependent care, or transportation expenses.

Benefits to the Employer

Employers may add an FSA Plan as a key element in their overall benefit package. Because an FSA Plan offers a tax-advantage, employers experience tax savings from reduced FICA, FUTA, SUTA, and Workers’ Compensation taxes on participating employees. These tax savings reduce or eliminate altogether the various costs associated with offering the plan. Meanwhile, employee satisfaction is heightened because participating employees experience a “raise” at no additional cost to the employer. Increased participation equals greater tax savings to the employer. Thus, to promote participation in the plan, employers may wish to contribute to each employee’s FSA account.

Benefits to the Employee

An employee who participates in the FSA must place a certain dollar amount into the FSA each year. This “election” amount is automatically deducted from the employee’s check (for that amount divided by the number of payroll periods). For example, an employee is paid 24 times a year, and elects to put $480 in the FSA. Thus, $20 is deducted pre-tax from each paycheck and is held in an account (by the plan administrator) to be reimbursed upon request.

Plan Year and Grace Period

The plan year is one full year (365 days) and generally begins on the first of a month. Many employers design their flexible spending plan to run on the same plan year as their insurance program. Short plan years are allowed in certain instances. The grace period is a timeframe up to 75 days after the end of the official plan year during which employees may use up any funds remaining at the end of the plan year. For example, if the plan year runs from July 1-June 30, the grace period for that plan may continue up to September 15. If an employee incurs an expense after June 30 but before September 15, they can utilize the remaining funds from the previous plan year and submit requests for reimbursement. In addition to the 75 day grace period, plan participants have an additional 90-day run-out period in which they can submit requests for reimbursement for expenses incurred during the dates of service within the plan year and grace period.

Uniform Coverage

This aspect of Section 125 allows an employee to be reimbursed for qualified medical expenses that exceed their contributions to date. While this is a great benefit for the employee, it poses a potential risk to the employer. A case in point is when an employee terminates with a negative balance in their medical FSA. This risk should be offset because some other employees do not spend all of their FSA funds, so the risk is minimal. This rule states that for the medical expense account, a participant may claim the full amount of their annual election even if they have contributed only a portion of the total. For example, Sue Summers decides to contribute $480 for the year to her FSA account. To accomplish this, $20 is deducted pre-tax from each of her 24 payrolls for the year. Her plan starts in January. In March, Sue experiences a medical expense that costs $400. To date, she has contributed only $20 on six payrolls, meaning she has only $120 actual dollars in her FSA account. However, due to the uniform coverage rule she can claim and be reimbursed for the full $400 because of the assumption that her bi-weekly contributions will continue and she will eventually contribute the $480 total. This honor system is a huge advantage for participants, and allows them to experience medical expenses at any time of the year with no worry about having the funds available at the time the expense is incurred. Uniform coverage applies to the medical FSA only; it does not apply to a Dependent Care FSA. With a Dependent Care FSA account, a participant’s reimbursement may not exceed the balance in the FSA account at the time the claim was made.

The Use-It-Or-Lose-It Rule and Carryover

This rule states that any funds remaining in the participating employee’s FSA account at the end of the plan year will be forfeited to the employer. Although the rule is clear, many users of an FSA largely misunderstand the result of the rule: loss of funds can be easily avoided. Let’s look at an example: Joe Smith chooses to participate in the Medical FSA and elects to fund $500 for the year. After the plan year and grace period are complete, Joe finds that he spent only $400 of the original $500 he put away. He fears he has lost $100, but due to the taxes he saved on the $500 he has not. Let’s say Joe is in the 28% tax bracket. By putting $500 away in his Medical FSA, he saved $140 in taxes (money that was not taken out of his paycheck and given to the IRS). In sum, even if Joe leaves $100 in his Medical FSA account, he has still saved $40! This vital key issue must be explained completely to potential FSA participants. Plus, with the new Carryover provision implemented on October 31, 2013, employees can carryover up to $500 of unused Medical FSA funds from one plan year to the next with no fees or penalties. Carryover enures the participating employee a safety net when determining how much money to set aside in a medical FSA each year. Employees can contribute funds with more confidence, knowing that they will not lose their funds (maximum carryover is $500) at the end of the plan year. Employees who participate in an FSA should determine the amount to fund by looking at the expenses they will incur in a year; this amount is not an arbitrary number. In this example, let’s say Mary Johnson is married with two children. One child is in daycare, Mary has glasses, and her husband Tom has allergies. When adding up how much to put away in her Medical and Dependent Care FSA accounts, Mary looks ahead for the year and determines that one child is going to need braces (add $2,000), that Mary is going to need glasses (add $500), and that Tom has a regular prescription for allergy medicine every month (add $120: $10 per month co-pay). Adding it all up, she determines her expenses add up to $5,000 for day care and $2,620 for medical expenses. Since the limit on the medical FSA for 2015 is $2,550 ($2,500 for plan years with a start date in 2014), Mary will elect $2,550 for the Medical FSA and $5,000 for the Dependent Care FSA. The total amount she will put away toward her FSA is $7,550. These are expenses she knows will be incurred. Once again, at an average 28% tax bracket, Mary will save $2,114 by using her FSA! That is equivalent to getting her child’s braces for free! She has no doubt that she should take advantage of her FSA and save this money. Cafeteria Plans are qualified, non-discriminatory benefit plans, meaning a discrimination test must be met based on the elections of the participants combined with any contribution by the employer.

Nondiscrimination Testing

Section 125 of the Internal Revenue Code requires that Cafeteria Plans be offered on a nondiscriminatory basis. To ensure compliance, the Internal Revenue Code sets forth testing requirements that must be satisfied. These testing requirements are in place to make certain that Cafeteria Plan benefits are available to all eligible employees under the same terms, and that the Plan does not favor highly compensated employees, officers, and owners.

irs.gov/publications/p15b 

Thompson Reuters  

Exceptions

Sole proprietors, partners in a partnerships, and more-than-2% shareholders in an S-Corporation have special considerations concerning participation in a Cafeteria Plan. While sole proprietors cannot directly participate in the plan, they may legitimately employ their spouse and offer the spouse the benefits of the plan. In such instances, the employer must take care to ensure that the plan must be offered on a non-discriminatory basis. The employed spouse may be considered a highly-compensated employee and as such their contributions to the plan may be limited. A partnership operates much like a sole proprietorship. While the partners cannot directly participate, they may employ a spouse who in turn may receive benefits. The highly compensated issues apply as stated above. While all non-related employees may participate in the plan, depending upon the plan’s parameters, non-discriminatory rules apply. In S-Corporations, eligible employees who are not shareholders and who are not defined as highly compensated generally may participate to the fullest extent. Eligible employees, who are defined as highly compensated, excluding shareholders, will be subject to the non-discriminatory rules. Special rules apply to a more-than-2% shareholder of the organization. These individuals may not participate in the plan; nor may their employee-spouse, children, parents, and grandparents. In determining the status of an individual that becomes or ceases to be a more-than-2% shareholder during the course of the S Corporation’s taxable year, the individual is treated as a more-than-2% shareholder for the entire year.  Copied from Tasc Online.com

References

Wikipedia US Tax Code §125 Cafeteria Plans

Aflac

IRS Publication 15 – Cafeteria Plans – Page 3    

16 comments on Ҥ125 Cafeteria Plan РFull Benefit

  1. my company offers employees health, dental, life, STD, LTD, AFLAC.

    We contribute @$500 toward health.

    Research tells me that when I setup the 125 plan, I need to offer cash vs. the non-taxable benefits.

    In other words, the $500 I’m paying toward health is mandatory to be given into paycheck as taxable income, if they don’t want to participate in any benefits. i.e. I have to provide same benefit level for all in the 125 plan…employees can then use that $500 p/month plus any of their own money to buy benefits.

    My question is….given I have to offer a taxable and non-taxable benefit…are companies required to pay the same contribution level to all in the plan??

    Click here for the most authoritative reply

    • I think what you are talking about is Cash in lieu of benefits My research below seems to indicate that someone who doesn’t want the health insurance, would not get $500 but a lower amount.

      A Cafeteria Plan (as provided for under Internal Revenue Code Section 125) is an employer sponsored plan under which employees have the option of selecting benefits or cash. Employees can choose which tax free benefits fit their needs, or may instead elect to receive taxable cash payments in lieu of unselected benefits.

      For example, under a Cafeteria Plan, employees may use salary reduction to pay their share of premiums for health insurance provided by their employer, with these payments made on a pre-tax basis. https://www.tasconline.com/biz-resource-center/plans/simple-cafeteria-plans/

      Many employees are in a position to choose between their employer’s plan and another program where they meet the eligibility requirements (i.e. spouse’s plan). A Cash in Lieu of Benefits program, or cash-out option, offers an incentive for those employees to waive the employer coverage and instead enroll in the other plan. The incentive is in the form of a cash payment added to their paycheck.

      the cash-out incentive is an after-tax benefit. https://www.johnsondugan.com/cash_in_lieu_of_benefits/

      In general, employers may treat employees differently, as long as they are not violating federal rules that prohibit discrimination in favor of highly compensated employees.

      Currently, fully insured health plans are not subject to nondiscrimination testing.http://www.safegardgroup.com/blog/2017/12/19/health-plan-treating-employees/

      When “cash in lieu of benefits” is offered to employees, the benefit cannot discriminate to employees based on “would-be” premium costs. Thus, the “cash in lieu of benefits” amount should be a single flat-dollar amount set by the employer, and should be consistently offered to all eligible employees. Furthermore, the option should not be provided to enable an employee to purchase an individual health policy.

      An example: The premium for the lowest-cost minimum value plan is $400/month. The employer contribution is 50%, so the employee pays $200/month. The employer also offers all eligible employees $100/month as a “cash in lieu of benefits” amount if they decline coverage.

      If the $100 “cash in lieu of benefits” amount must be counted into ACA affordability because the “cash in lieu of benefits” option is not considered an “eligible opt out arrangement,” the employee cost for self-only coverage will be $300/month ($200 premium + $100 “cash in lieu of benefits” amount). From the IRS’s perspective, the employee has to forgo the $100/month “opt out” amount in addition to having to pay the $200/month for coverage.

      If the opt out payment does not have to be counted because it is considered an “eligible opt out arrangement,” the employee cost for self-only coverage will be $200/month.
      Employers should always include “cash in lieu of benefits” polices in their employee handbooks. This allows for transparency and equal treatment of all employees across the board. It also helps protect the employer against potential ERISA violation concerns because of this transparency and fair treatment.

      If employers feel uncertain setting up a “cash in lieu of benefits” option, it is best to refer them to legal counsel or a CPA to ensure full compliance with the law. https://www.wordandbrown.com/compliance/offering-cash-in-lieu-of-benefits-compliance-considerations

      • the $64,000 question is this:

        company offers employees health insurance. Total premium cost is $600 p/month for employee only coverage. Company offers to pay $500 of this cost to any employee that wants insurance. Section 125 states, that in order for the premium to be a pre-tax amount for the employee, the company has to have a section 125 plan document. Company pays the $600 directly to Blue Cross Blue Shield and deducts $100 from the employees check on a pre-tax basis.

        Section 125 also states, that to be a valid plan you must offer the employee a taxable “benefit” such as cash OR the pre-tax basis health premium.

        What nobody seems to be able to clearly answer is:

        What constitutes the taxable benefit???

        Is it the salary they were already entitled to? To me this is not a benefit. Employees are entitled to this whether we offer insurance or not. To me the benefit is the $500 the company is willing to pay toward Health Insurance.

        The way I read Section 125….if employees don’t want the insurance, they should be offered the $500 into their salary (on top of / in addition to) and that becomes the taxable “benefit”.

        However, some are telling me no….the “opt outs” get their full salary and that is considered the cash benefit option…..This makes no sense to me…but if it’s the proper interpretation, then so be it.

        I need to make a recommendation to my company, and so far I’m inclined to tell them that to be compliant, we have to offer the same benefit to all to qualify for Section 125, and that means paying the $500 into their salary if they opt out, and if they opt in…they get the $500 and use it to pick what benefits they want, which are then tax Free.

        Can ANYONE clarify this for me from a legal/IRS perspective???

        • Under a Section 125 plan, employees choose between at least one taxable benefit (such as taxable compensation) and one or more qualified benefits. Qualified benefits include, for example, the following commonly offered employee benefits:

           Group health plans;
           Vision and dental plans;
           Disability and life insurance;
           Health flexible spending accounts (FSAs);
           Dependent care assistance programs (DCAPs); and
           Health savings account (HSAs).

          According to the IRS, a Section 125 plan is the only means by which an employer can offer employees a choice between taxable and nontaxable benefits without causing adverse tax consequences to the employees. To avoid taxation, the Section 125 plan must meet the specific requirements of Code Section 125 and underlying IRS regulations. https://www.sullivan-benefits.com/wp-content/uploads/Section-125-Cafeteria-Plans-Overview.pdf

          • A cafeteria plan, including an FSA, provides participants an opportunity to receive qualified benefits on a pre-tax basis. It is a written plan that allows your employees to choose between receiving cash or taxable benefits, instead of certain qualified benefits for which the law provides an exclusion from wages. If an employee chooses to receive a qualified benefit under the plan, the fact that the employee could have received cash or a taxable benefit instead won’t make the qualified benefit taxable.

            Qualified benefits.

            A cafeteria plan can include the following benefits discussed in section 2.
            Accident and health benefits (but not Archer medical savings accounts (Archer MSAs) or long-term care insurance).
            • Adoption assistance.
            • Dependent care assistance.
            • Group-term life insurance coverage (including costs that can’t be excluded from wages).
            • Health savings accounts (HSAs). Distributions from an HSA may be used to pay eligible long-term care insurance premiums or qualified long-term care services.https://www.irs.gov/pub/irs-pdf/p15b.pdf#page=3

        • What constitutes the taxable benefit???

          Is it the salary they were already entitled to?

          To me this is not a benefit.

          Employees are entitled to this whether we offer insurance or not. To me the benefit is the $500 the company is willing to pay toward Health Insurance.

          • I think we have a semantics and confusion issue here.

            Let’s say two employees are currently earning $5k/month.

            One has you put the $500 health benefit towards health insurance, he does not have to show income and pay taxes.

            The other employee takes the cash… on top of the salary he’s already getting and would have to pay taxes on it.

            See our page on Section 125 Premium ONLY Plans for tax calculators.

            If everything you are providing is Insurance and not an FSA Flexible Spending Account you might consider the POP plan. The administration cost is a lot less. How many employees do you have?

            • Ok..we are closer….I agree with you that the person in a pop plan that opts out should get the 500 in addition to their salary….but some are telling me NO…section 125 does not require the employer to give the 500 to those who opt out…

              So what is happening here is employee A, opts in…we deduct 100 per month from.their paycheck free of tax…company pays that 100 deducted plus our 500 to blue cross.

              The opt outs…get nothing but their original salary. To me that is not a choice of benefits.

              Many are telling me that there is no requirement to the employer in section 125 that compels the company to pay the opt outs the same 500 dollar benefit we provide the opt ins….

              So ultimately while i k ow we CAN give the 500 to the opt outs..does section 125 REQUIRE it as the taxable benefit choice versus the tax free choice of health benefit.

              That’s what I’m after. I feel our company is required by section 125 to pay in the 500 to all eligible even if they opt out of benedits..in order foe those who opt in to be allowed to deduct their premiums tax free.

              Very confusing and hard to explain.

      • Reply from Wholesaler # 2

        Employers can offer a “cash in lieu of benefits” or “pay in lieu of benefits” option, under which the employer offers an employee a taxable “opt out” amount, if the employee declines coverage under the employer’s group health plan because the employee has other group coverage or coverage under a spouse’s group health plan. Some employers require employees to certify that they have other coverage in order to opt out of the group health plan, while others allow employees to opt out even if they do not certify they have other coverage. Please note that the section below titled, “Eligible Opt-Out Arrangement” includes a requirement for Applicable Large Employers to collect attestation forms.

        From my understanding, the opt out benefit is a set amount determined by the employer. If the client is unsure how to set up a cash in lieu of benefits option, or has any further questions please refer them to their CPA.

        Employers thinking of offering a cash in lieu of benefits option should offer it in a way where they are not incentivizing or encouraging its employees not to enroll in the group’s health plan.

        The cash in lieu of benefits option should be outlined in the employee

        Although it is legal to offer a cash incentive to employees who opt out of the employer’s group health plan, keep in mind that this option will always be taxable.

        Additionally, there are other important considerations:

        • The option should be offered alongside a Premium Only Plan (POP) so employees who elect group health plan coverage (not taxable cash) will not have taxable income.
        • The “cash in lieu” amount will have to be counted in the “affordability” determination for Applicable Large Employers (ALE) under the Affordable Care Act (ACA), unless it qualifies as an “eligible opt out arrangement.” Please see below for a listing of the six criteria that qualifies as an Eligible Opt-Out Arrangement.
        • If an opt-out payment must be counted in the affordability calculations, it will be counted for ALL full-time employees, both those who enroll in the employer group health plan and those who decline coverage and receive the opt-out payment instead. The affordability amount must be entered on IRS Form 1095-C, part II, line 15.
        • The option should not be provided to enable an employee to purchase an individual policy, whether on or off the exchange. For this reason, an attestation form is a safeguard for employers of all sizes.
        • The option should be offered to all eligible employees, not just to a select few, and should not be offered primarily or exclusively to employees who have high claims.

        Example: The total cost for self-only coverage is $400 per month, of which the employer pays $310 and the employee pays $90. The employer also offers all eligible employees $75 per month if they decline coverage. If the $75 opt-out payment must be counted, the employee cost for self-only coverage will be $165 per month ($90 +$75). If the opt-out payment does not have to be counted, the employee cost for self-only coverage will be $90 per month, which is less than the FPL safe harbor of $96.08 per month for 2018 and $99.75 for 2019.

        IRS Notice 2015-87, addresses the treatment of employer opt-out payments for purposes of the Employer Shared Responsibility “Affordability” test, and for other guidance.

        IRS Notice 2012-40, outlines that a section 125 cafeteria plan is a written plan that allows employees to elect between permitted taxable benefits (such as cash) and certain qualified benefits.

        We also have an article published on our website titled, Offering “Cash in Lieu of Benefits” – Compliance Considerations, that is worth checking out.

        Eligible Opt-Out Arrangement
        “CONDITIONAL” ARRANGEMENT THAT MEETS ALL SIX CRITERIA:

        1. The employee must provide “reasonable evidence” that the employee and dependents are expected to have minimum essential coverage (MEC) for the relevant period (the plan year for which the opt-out payment is offered).
        2. MEC cannot be coverage in the individual market (on or off exchange); but it can be government coverage such as Medicare Part A, most Medicaid, CHIP and most TRICARE programs.
        3. “Reasonable evidence” may be the employee’s attestation.
        4. Reasonable evidence/attestation must be provided at least annually.
        5. Reasonable evidence must be provided no earlier than a reasonable period of time before coverage starts (e.g., at open enrollment), and the employer can allow employees to provide it after the plan year starts.
        6. The arrangement must provide that the employer cannot make opt-out payments (and the employer in fact must not) if the employer knows or has reason to know that the employee or family member does not or will not have MEC.

        https://www.wordandbrown.com/compliance/offering-cash-in-lieu-of-benefits-compliance-considerations

        https://www.irs.gov/pub/irs-drop/n-12-40.pdf

        https://www.irs.gov/pub/irs-drop/n-15-87.pdf

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