Section 125 Cafeteria Plan information


1. What is Section 125 Cafeteria Plan and why is it important?

The Revenue Act of 1978 established Cafeteria or Flexible Benefit Plans. Section 125 of the Internal Revenue Code is the primary regulatory source for such Plans.

2. What does a Cafeteria/Flexible Benefit Plan do?

It allows employees to pay for certain benefits with before taxed dollars. Basically, a Plan can consist of three separate, independent parts:

  1. Insurance Premiums Employees may pay for their portion of their employer-sponsored health, life, dental, disability, etc. insurance coverages on a before-tax basis.
  2. Dependent Child Care Expenses Employees may pay for Dependent/child care expenses on a before-tax basis.
  3. Flexible Spending Accounts Employees may elect to establish flexible spending accounts into which a portion of their pre-tax wages will go. Monies will be held for them and reimbursed tax free as medical type expenses are incurred by the employee and dependents. Reimbursements must be made for expenses not covered by any insurance coverages.

3. Does a Cafeteria Plan have to consist of all the 3 parts?

No. As mentioned, a Plan can consist of one, two, or all three of the different parts.

4. Can a sole proprietor, partnership, or S-corporation have a Plan?

Yes. However, the owners or partners may not participate.

5. Does the Plan have to be based upon a calendar year?

No. However, most Plans are calendar year. The first year of a Plan can be a short year, thus allowing you to become a calendar year Plan in January.

6. What are the specific benefits of a Plan to an employer?

When an employee participates in a Plan, that employee is reducing his taxable wages. As a result, the employer's payroll is less. If the employer's payroll decreases, so do some of the expenses associated with payroll: Social Security (FICA) contributions, and in some instances, worker's compensation and unemployment insurance costs. The employer will save at least 7.65% of whatever employees run through their Plan.

In addition the employer benefits because the effects of the Plan on the employees are positive. Employee net earnings will increase because taxes will decrease. The result is that the employer is able to offer a true benefit to the employees and will be able to take the credit for offering it !

7. What is a PREMIUM ONLY PLAN ... and how does it work?

Employees who are paying any portion of their employer-sponsored group insurance (either for single or dependent coverage), may do so under the Plan on a before-tax basis. If, for example, an employee is paying $200 per month for his portion of the insurance premiums, this $200 would no longer be subject to FICA taxes, thus saving him 7.65%, or $15.30 per month. In addition, the employee's premium of $200 would no longer be subject to Federal Income Tax. The employee would save an additional $30 (15% Federal Tax Bracket), or $56 (28% Federal Tax Bracket) depending upon his total income, etc. In most areas, the employee would also be able to save any state and city taxes. The bottom line, depending upon the employee's Federal Tax Bracket, is a possible total tax savings of between $45 and $62 per month.

8. Do benefits change?

Do you have to change insurance carriers?
No. All benefits will remain exactly the same as before. The only difference is that the employee's paycheck, his net take-home pay, will increase, because his taxes have decreased.

9. Will Social Security benefits be affected?

Possibly. Because the employee is contributing less into Social Security, it is possible that benefits may be slightly reduced. However, for most people the current tax savings (anywhere from a minimum of 23-35%) is much greater than any potential reduction in Social Security benefits.

10. Should an employer adopt a PREMIUM ONLY PLAN?

Yes. A PREMIUM ONLY PLAN (POP) is relatively simple and inexpensive to install. Employees will immediately benefit by having their paychecks increase.

11. Speaking of administration, what does a POP require?

Once established, a POP does not require any specific on-going administration. Payroll will be altered as insurance premiums/contributions change.

12. What does an employer need to do to adopt a POP?

Since a POP is a plan, a Plan Document is required. In addition, Summary Plan Descriptions must be created and distributed to employees. Every year, form 5500 must be completed and returned to the IRS. Employees must be given the opportunity to enroll in the Plan, so election forms must be completed.

13. Why does an employer need an installation kit ... what does it have in it?

The kit has all of the necessary forms, instructions for completing them, and helpful hints for the bookkeeper/controller that an employer needs to install the Plan. The Plan Document, Summary Plan Description, sample letter to the Department of Labor, complete instructions on how to complete IRS form as well as the actual form for the employer to use are all included in the Kit.

14. What if the employer pays 100% of the insurance costs?

If employees don't participate in the cost of the employer-sponsored group insurance, there is no need for the POP. The fact that the POP is available, however, may allow employers to start charging employees a portion of the insurance costs. For every dollar the employer makes the employee pay for coverage, Uncle Sam will be picking up from at least 23-35 cents through the POP.

15. Should an employer offer Dependent/Child care and Flexible Spending Accounts in addition to the POP?

Possibly, but after the POP has been successfully communicated and installed. Employees should have a few months of comfort with the concept of Section 125 before more complicated aspects of the plan are introduced.

16. Does a POP affect contributions to a retirement plan?

Retirement plans should be amended, if necessary, to include POP contributions as compensation for purposes of the contribution. The result is that POP will have no negative affect on retirement plans.

17. What about discrimination and POP?

Most small employers rarely have a problem with discrimination under a POP. The Kit does have a section on discrimination testing . Please call for advice.

18. Congress is looking for more tax dollars ... is POP safe?

Congress is looking for more tax dollars, but POP appears to be safe for several reasons. First of all, the cost of health insurance is so great and is escalating so fast that most Americans may be forced to go without. POP reduces employee insurance costs, thus enabling employees to maintain coverage. Secondly, POP now affects millions of workers; public reaction alone may be enough to control Congress. Finally, employers should adopt a POP as soon as possible in case Congress does legislate against POP. Employers and their employees can save taxes NOW, and any action by Congress would probably have an effective date in the future, thus allowing past reductions to remain.

401(k) Plans for Any Size Business More and more, employees are beginning to realize they must save money on their own to plan for a sound retirement. For many, this means looking for help in meeting future financial goals.

At the same time, employers have limited dollars to spend on labor costs, including both salaries and benefits. So it makes sense to spend those dollars as cost-effectively as possible. Employer-provided retirement plans, such as 401(k) plans, can help meet the financial goals of both employers and employees, while providing other benefits as well.

Gardner G. Cook
Principal Consultant
Cook & Associates
Phone 707-935-7362
Fax 707-933-9131
ggc@cookandassociates.org