Section 125 Cafeteria Plan Explained

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Should You Offer a Section 125 Cafeteria Plan?


What is a cafeteria plan?

A Section 125 Cafeteria Plan is a benefits package that employers can offer employees. This is a plan that was set forth by Section 125 of the Internal Revenue Service code. It is referred to as a Cafeteria Plan because it provides employees with the ability to choose the benefits they want like they are choosing off a Cafeteria menu.

An employer can offer many types of benefits to employees through this type of plan. To offer a Cafeteria plan an employer has to offer at least one qualified and one non-qualified benefit to employees. Some of the qualified benefits could include health, dental and/or life insurance, dependent care services, adoption assistance and a retirement plan. A non-qualified option could be a cash bonus plan. The employee has the ability to choose a certain number of benefits depending on their situation. The written plan must specifically describe all benefits and establish rules for eligibility and elections.

One of the potential drawbacks for employees with this type of plan is that you have to use the benefits or lose them. When you contribute money to a flexible spending account, it has to be used in the same calendar year. If you do not use the money on health expenses, you lose all of it. Then you have to start contributing again the next year for that year’s expenses. This makes it difficult to plan for how much you will need to save out of each paycheck. Recently however, the IRS announced that employers may elect to allow participants to carry over up to $500 in unused FSA funds to the following year. But an employer can’t offer both the carryover provision and the grace period. It’s one or the other.

Deductions under such agreements are often called pre-tax deductions. Salary redirection contributions are not actually or constructively received by the participant. Therefore, those contributions are not generally considered wages for federal income tax purposes, nor are they usually subject to FICA (social security and medicare) and  FUTA (an employer paid employment tax) taxes.

Reasons for implementing a Section 125 plan are primarily for the tax savings advantages for the employer and employee. Both parties save on taxes and therefore increase their spendable income. Employees’ pretax contributions are not subject to federal, state, or social security taxes. Employers save on the employer portion of FICA, FUTA, and workers’ compensation insurance premiums.

Is there a filing requirement for a cafeteria plan?

Generally, no. If you only have a cafeteria plan, you are not required to file Form 5500 or Schedule F. However, if you have a welfare benefit plan, you may be required under Department of Labor regulations to file a return for that plan.

In order to implement a Section 125 plan, a written benefit plan must specifically describe all benefits and establish rules for eligibility and elections. Therefore, it is advisable to use a benefit administrator to set up and administer the plan in order to avoid the IRS from deeming the plan not conforming to their requirements and therefore null and void. Typically, the costs of administration out way the tax saving benefits for companies with less than 25 employees. Therefore, you should first conduct some research as to administration costs prior to implementing such a plan.

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