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Section 125
What is a Section 125 Cafeteria Plan?
Section 125 Plans are called by a variety of names: pretax plans,
cafeteria plans, salary reduction plans, and salary redirection plans.
But all these names refer to plans designed to reduce taxes for employers
and their employees under Section 125 of the Internal Revenue Code.
Section 125 permits employees to pay for certain benefits before taxes
through pre-tax deductions from their paychecks. These pre-tax deductions
have the effect
of lowering the employee's taxable income. Consequently, the employee
pays less in FICA and Federal withholding taxes. Most employer sponsored
insurance plans
qualify to be "pre-taxed." This includes employee-paid costs for medical
insurance, dental insurance, group term life insurance and a variety of others.
In addition, dependent-care expenses (usually child-care) and many kinds of
vision, dental and medical expenses can be "pre-taxed."
Also, employee's taxable earnings, the company will reduce
its FICA tax liability by 7.65% of every employee dollar that is deducted
before taxes. The employees' total tax-savings will usually range from
17.65% to 46.25% (marginal tax rate + FICA). Most employees fall into
either the 22.65% or the 32.65% category. This means that every dollar "pre-taxed" will
save an employee in the 25% marginal tax rate about 33 cents (25% +
7.65%).
This is not a temporary saving that must be repaid
at the end of the year when the tax return is filed. For both the employer
and the employee, it represents permanent tax-savings (a true win-win)
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Two Types of Section
125 Cafeteria Plans: POPs and FSAs Premium Only Plans (POPs)
Premium only Plans (usually called "POPs")
are designed to reduce taxes on insurance premiums only. The portion
of the premiums paid by the employee
can be pre-taxed under the plan. Most insurance premiums qualify. For many
groups, setting up a POP is all that is required for both the company
and its employees
to realize substantial tax-savings. How Pop Plans work: An Example
Let's look at an example in which an employee making $3,000 per month pays
insurance premiums in the amount of $500 per month. The first column illustrates
how the employee's take - home pay is calculated if there is no Section
125 Pop Plan. The second column shows the tax- saving effect of implementing
a POP Plan.
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Flexible Spending Accounts (FSAs)
These plans include all of the
insurance premium tax-savings benefits of POPs but also adds the
additional tax-savings potential for two
other categories of expense. The first category is employee dependent-care
expense
(usually childcare,
but adult custodial care is permitted under some circumstances). The
second category is expenses for medical-dental-vision expenses not
covered by insurance.
With Flexible Spending Accounts (or "FSAs"), the employee is permitted
to avoid paying taxes, subject to an annual limit, on dependent-care
expenses and an amount of medical-dental-vision expense potentially
limited only by the employee's income.
How Section 125 Plans with Flex Accounts Work:
Let's look at an example in which an employee making
$3,000 per month pays insurance premiums in the amount of $500 per
month, child-care
in the amount of $400 per month and un-reimbursed medical, dental
or vision expenses averaging $100 per month
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