Cafeteria plans offer pre-tax savings

Many employee benefits and insurance directly affect an employee’s paycheck through the form of payroll deductions. Many times, payroll tracks paid time off benefits through an employee’s timecard.

But one of the most important links between payroll and benefits comes in the form of a cafeteria plan.

Cafeteria plans were created by Section 125 of the Internal Revenue Service code. They were nicknamed cafeteria plans because they allow employers to determine what benefits will be included in a buffet fashion.

Options range from employer-sponsored health insurance, premium-only plans to the addition of medical spending accounts, dependent care accounts, transportation expense accounts and even non-employer sponsored health premium plans. They have several names: Section 125 plans, cafeteria plans, flexible spending accounts and flex plans, but the advantage is the same to the employer and the employee – they save tax dollars.

Cafeteria plans save employers and employees money by rearranging the order in which deductions are calculated. Traditionally, tax deductions are made first from an employee’s wages. Therefore, taxes are calculated based upon an employee’s total gross salary. In a cafeteria plan, any deductions for qualified expenses that are part of the plan are taken from the gross salary before tax deductions are calculated. This allows those expenses to be sheltered from taxes.

Deductions made through a cafeteria plan are exempt from all payroll taxes, including Social Security and Medicare, as well as from individual state and federal income tax withholdings. This can mean payroll tax savings for the employer of nearly 10 percent and can range from an average savings of 25 percent on up for an employee, depending on the employee’s individual tax bracket.

In an environment where everyone is looking to control health care costs, employers who are not utilizing a cafeteria plan should consider it. Cafeteria plans can be an easy and cost-effective way, to reduce tax liability and make employees health insurance premiums more affordable.

Because of the ability to take qualified expenses and not pay taxes on that money, cafeteria plans, once implemented, do require administration to keep them compliant with IRS regulations. Generally, open enrollment periods must be offered every year. Many times, plan documents require employers to have employees opt in or out of the plan annually. Employers with cafeteria plans should review their plan documents to determine when open enrollments need to be offered, what documentation should be collected from the employees and how they will communicate open enrollment periods to their employees.

Cafeteria plans also place requirements on when changes to the deductions or plan contributions can be made. When a cafeteria plan is in place, employees are limited to making deduction or contribution changes only during open enrollment periods or when a qualifying event has taken place. Employers should be careful to understand the plan requirements to maintain a qualified cafeteria plan.

Notice 2005-42

This year, the IRS announced some striking plan guidance in the form of Notice 2005-42. Specifically, this notice provides that a cafeteria plan can be drafted to allow reimbursements of expenses incurred during a two-month grace period following the close of the plan year.

One of the traditional requirements of a spending account is that expenses must be incurred during the plan year. Notice 2005-42 allows a plan to be written in such a way as to allow expenses to be incurred during the grace period. This gives employees more flexibility to use and manage their cafeteria plan dollars. However, for employers to take advantage of this rule, the plan document must be adjusted. According to this notice, a plan can be amended to provide for a grace period anytime prior to the end of the current plan year. For a calendar year plan, this means that as long as the amendment has been adopted by Dec. 31, the grace period can be made available for the 2005 plan year.

Employers who want to establish cafeteria plans or who need to make changes to an existing cafeteria plan have many options. Talk to your insurance agent, accountant or payroll company for additional information and resources. Assistance is available to be administered in-house, or they can be handled by independent plan administration companies. Many times, a payroll department or outsourcing company will be able to provide specific information to estimate your company’s potential savings with a plan, monitor eligibility and provide other useful reports. The level of help you need to take advantage of the savings a cafeteria plan has to offer is available.

Many employers decline to offer a cafeteria plan due to fear of what may be involved. Through the assistance of professional payroll services, insurance brokers or other specialized companies, cafeteria plan administration can be simplified to allow your company to take advantage of the tax laws to reduce your total tax burden.

Jeff Hunter is president of The Payroll Co. [[In-content Ad]]