How much of your budget is allocated to? In the past, this may have represented just a sliver, but now frequently take a much larger piece of the pie.
Strategy: Set up a Section 125 “cafeteria plan” that provides a menu of tax-favored fringe benefits to choose from. Participating employees only take advantage of those benefits they truly want, helping to keep company costs down.
Usually, contributions to a cafeteria plan are made through a salary reduction plan. The employees’ contributions are subtracted from their taxable salaries for federal income tax and employment tax purposes. In addition, the salary reduction amounts are not subject to the employer’s share of federal employment taxes.
Here’s the whole story: A cafeteria plan must be a separate written plan maintained by an employer for employees under Section 125 of the Internal Revenue Code. It gives participants the opportunity to receive certain benefits on a pretax basis. Participants in the cafeteria plan must be permitted to choose among at least one taxable benefit, such as cash salary, and one qualified tax-favored benefit (see box below).
The written cafeteria plan must specifically describe all benefits and establish rules for eligibility and elections. This is the only way in which an employer can offer employees a choice between taxable and nontaxable benefits without having the choice cause benefits to become taxable. A plan offering employees only a choice of taxable benefits is not a Section 125 plan.
The plan can make benefits available to employees, their spouses and dependents. It may also include coverage of former employees, but it can’t exist primarily for ex-employees.
Generally, employer contributions to the cafeteria plan are made pursuant to salary reduction agreements between the employer and the employee in which the employee agrees to contribute a portion of his or her salary on a pretax basis to pay for the qualified benefits. Salary reduction contributions aren’t actually or constructively received by the participant. Therefore, those contributions are not considered wages for federal income tax purposes. In addition, those amounts are generally not subject to Social Security, Medicare, or FUTA taxes (collectively referred to as federal employment taxes).
However, group-term life insurance exceeding $50,000 of coverage is subject to Social Security and Medicare taxes, but not FUTA tax or income tax withholding, even if it is provided as a qualified benefit in a cafeteria plan. Adoption assistance benefits provided in a cafeteria plan are subject to federal employment taxes but not income tax withholding. If an employee elects to receive cash instead of any qualified benefit, the payment is treated as wages subject to all income and employment taxes.
How does a cafeteria plan differ from a flexible spending arrangement (FSA)? An FSA is actually a form of a cafeteria plan benefit, funded through salary reduction that reimburses employees for expenses incurred for certain qualified benefits. It may be offered for dependent care assistance, adoption assistance and health care reimbursements, within certain limits (e.g., annual contributions for health care can’t exceed $2,500). However, employees must cope with the “use-or-lose” rule on funds.
Under this rule, any amount left over in an employee’s account at the end of the plan year is forfeited. An employer can choose to allow a 2½ month “grace period” after the end of the year for using up funds. Update: The IRS recently announced that employers may elect to allow participating employees to carry over up to $500 in unused FSA funds to the next year. But an employer can’t offer both the carryover provision and the grace period. It’s one or the other.
Tip: Generally, there are no special filing requirements for cafeteria plans.
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