Section 125 benefits aid employees, bottom line

by Mike Scott

for the Business Journal

Health insurance costs are escalating at an alarming rate, causing employers to look for ways to reduce these costs. Some are trading benefit levels and some are shifting more of the cost to the employees.

Meanwhile, employees are also looking for ways to reduce those costs without losing any benefits.

The good news is that there is a way for both employers and employees to save money.

The employer can reduce the cost of payroll taxes without cutting the payroll. And employees can save not only on health insurance costs, but also on the cost of child care or other big-ticket expenses, like orthodontics or radial keratotomy.

Sound too good to be true? Thanks to Congress, the Cafeteria Plan or Flexible Spending Account under Section 125 of the IRS code allows employers and employees the opportunity to make contributions to several benefit categories on a pre-tax basis.

So if you are going to spend that money anyway, why not do it tax-free?

Congress created cafeteria plans in 1978, and originally, medical expenses were 100 percent deductible. However the Tax Reform Act of 1986 changed the deduction for medical expenses to only the amount of expenses that were in excess of 7.5 percent of your adjusted gross income.

This restriction on deductions for medical expenses means depending upon your income level you could realize some significant tax savings through the use of a cafeteria plan.

Section 125 plans provide both the employer and employee tax shelter for certain health care- related expenses. The employee benefits by taking the deductions for insurance premiums, dependent care expenses and unreimbursed medical expenses on a pre-tax basis.

The employ-er benefits by paying less in payroll taxes because the pre-tax deduc-tions lower the taxable in-come by at least 7.65 percent (6.2 percent for FICA-Social Security tax and 1.45 percent for Medicare tax). The employer will also realize savings on state and federal unemployment taxes.

There are primarily three types of accounts that can be utilized in Section 125 plans: insurance premium expenses, unreimbursed medical expenses, and dependent care reimbursement.

Many types of insurance qualify for the premium expense account including: major medical, cancer, accident, dental, vision, disability and term life up to $50,000.

The UME account can only be used for expenses not covered by the employees' insurance. Examples include deductibles, co-payments, dental and vision-related expenses.

Individuals estimate the annual cost for non-covered expenses and contribute a monthly amount before taxes are withheld to cover these expenses.

Be careful when determining the amount to be withheld for these items because the IRS codes do not allow the mixing of funds and do not allow the return of your unused contributions. You can, however, receive funds up to the maximum annual contribution at any time during the plan year.

The DCR account can only be used for expenses related to the care of dependents under the age of 13 or dependents who are physically or mentally unable to care for themselves.

Married couples who file jointly may contribute up to $5,000 per year to the DCR. The DCR account reimburses only funds that have been contributed through that point in time.

How much can a Section 125 plan save you? Let's look at an example of the savings of a cafeteria plan for both the employer and the employee. See the charts on page 36.

The first example reviews the employer's savings. An employer with an annual payroll of $500,000 can save at least $2,295 annually if the cafeteria plan contributions are $30,000.

The second example shows the employee's tax advantages from making contributions to a Section 125 plan on a pre-tax basis. Just by changing how an individual spent the same money, the employee's spendable income increased by more than $100 per month.

Any plan involved with the IRS has rules and regulations that govern its administration. One rule deals with election changes in Section 125 benefits.

These changes are based on qualifying events such as marriage or divorce, death of a child or spouse, birth or adoption of a child, or termination of a spouse's employment.

One of the most misunderstood rules concerns the excess funding of health care spending accounts.

While you cannot receive a dividend or premium refund based on your individual account's claims experience, all plan participants can get a refund or dividend on a reasonable and uniform basis.

There are certain people who are not eligible to participate as an employee in a Section 125 plan. They are sole proprietors, partners within a partnership or shareholders with more than 2 percent of the shares of an S-corporation.

Record keeping is an important part of the success of a Section 125 plan. Required records include:

?total number of employees

?total number of employees eligible to participate in the plan

?total number of employees participating in the plan

?total cost of the plan during the year

?the employers name, address and Federal Tax Identification number

?the type of business in which you are engaged.

These records are necessary for filing Form 5500 for plans with 100 or more participants or Form 5500C-R for plans with fewer than 100 participants. The deadline for filing is the last day of the seventh month after the plan's year end.

Typically there are costs associated with the implementation of a Section 125 plan, but these are usually offset by the savings realized by the plan participants. Some insurance carriers are willing to administer the plan at no cost, but it is still the responsibility of the business to file the proper forms and maintain the required records.

According to Springfield CPA, Leslie Huff, of Huckstep and Associates,

"Many smaller firms do not realize the benefits of installing a Section 125 plan," Huff said.

First year implementation costs are generally higher than the year-to-year administration costs of the plan.

However, as you can see from the previous examples, you and your employees can have significant rewards from these plans.

As always, before making these types of business decisions, you should consult your employee benefits insurance agent and your accountant or tax adviser.

(Mike Scott is a member of the employee benefit division of BPJ Insurance.)