By T. Michael Regan, C.P.A.
Something for nothing? Never! For centuries alchemists tried to turn lead into gold. As far back as Adam, people have found that a “free lunch”, even if it was only an apple, came with a cost. So, an employee benefit plan where both the employer and the employees come out ahead must be an impossibility. Maybe not.
The possibility of a costless benefit plan comes from a single concept. In every financial transaction there are at least three parties: the payer, the payee and the government. When you pay your employees, both you and they pay taxes. Through payroll withholding or otherwise, employees must remit income taxes to a variety of governmental agencies. They also pay to fund both the Social Security (FICA) and Medicare systems. You, then, match the amount which they pay to the Social Security Administration and Medicare. Cafeteria plans provide a means to partially exclude the government from a part of the payroll transaction.
What is a cafeteria plan? As its name suggests, a cafeteria plan allows an employee to choose where his or her benefit dollars will be spent. The plan can provide a number of selections, including medical, accident, disability, vision, dental and group term life insurance. It can reimburse actual medical expenses. It can pay children’s day care expenses. And, it does these things with pre-tax dollars. One thing to remember is that these benefits must be funded with tomorrow’s earnings, not yesterday’s. By that I mean, each person must estimate the costs that he or she will incur during the plan’s upcoming year and request to have the estimated amount redirected from wages into the plan.
One important key to the successful implementation of a cafeteria plan is properly informing your staff of the plan’s positive and negative aspects. You are asking your employees to transfer some amount of future wages into your cafeteria plan. What do they get out of it? Naturally, such a plan allows a small business to offer benefits which would be otherwise unaffordable. Beyond the added variety of options, however, are the real tax savings to the employees.
For example, if a person pays $2000 for day care through a cafeteria plan rather than making the payments personally out of earned income, he or she will, of course, see a decrease in take home pay. This decrease should be compared to the cost of paying for the same services in after-tax dollars. The amount redirected to a plan is excluded from taxable income for federal income, Social Security and Medicare tax purposes. It is also excluded from tax by most states other than Pennsylvania. As a result, an individual in only the 15 percent federal tax bracket would save $300 in federal tax and $153 in Social Security and Medicare tax in addition to any state tax. The reduction in take home pay would only amount to $1547, less than the amount the employee would have to pay personally.
The total amount someone can save increases directly with the rate at which the person pays federal tax. The savings are further amplified when you consider the impact of another type of benefit, medical expenses, which may be difficult to deduct on an individual’s tax return as an itemized deduction. In this latter case, the $1547 cost must be compared to the amount that the person would need to earn to acquire $2000 in order to pay for the medical expenses. For someone in a 15 percent tax bracket, that amount is $2585, without any consideration for state taxes.
Again, staff education about cafeteria plans must explain both the upside and downside potential of participating in the plan. All of the goodwill you gained from installing the plan could go out of the window if your employees are later surprised by one of the less favorable aspects. For example, redirecting wages which would be otherwise taxable for Social Security purposes may ultimately result in slightly lower government benefits at retirement. Payments made from a plan for dependent care are not eligible for the child care credit computation on an individual’s federal tax return. Further, once employees elect to shift a portion of their salaries into the plan, the election is not revocable except under specific circumstances, such as changes in marital status, number of dependents or spouse’s employment. And, any funds unused by the end of the plan year are also not refundable and will be forfeited by the participant. Consequently, preliminary counseling should emphasize the need to make accurate estimates of the actual expenses to be paid during the year. Naturally, the difficulty of making such estimates varies depending upon the benefits offered in the plan. Insurance premiums can be easily predicted, as can child care. Medical expenses may be a different story, however, and your employees must be forewarned.
Where does the employer derive benefit in all of this? First, there is a matter of goodwill as was mentioned above. Somewhat more measurable, however, are the monetary savings to the business. As the taxable wages for Social Security and Medicare are reduced, so are the related taxes which must be paid be the employer. In general, these taxes decrease by $765 for every $10,000 of benefits paid through the plan on behalf of individuals who have total earnings less than the Social Security threshold. Consider a practice where 12 people elect to redirect $100 per month into a plan. The annual savings for the employer would exceed $1100.
What about any downside potential for the employer? Cafeteria plans share certain administrative hassles with retirement plans. For example, the plan must be in writing. Elections to participate must also be written. A cafeteria plan must not discriminate in favor of the highly compensated employees and must be tested for discrimination annually. Any benefits received by the highly compensated group from a discriminatory plan become taxable to them. The plan must also file a tax return, Form 5500. Although the tax return is purely informational and results in no tax liability, there are strict penalties for delinquency or failure to file the return.
Cafeteria plans do not necessarily share the same complexity as retirement plans, however. The tax return is not as lengthy as that filed for a retirement plan. Nor does it require the same detailed record keeping. Once written, cafeteria plan documents may not require amendment unless benefits are added. Finally, relatively simple plans can be economically effective while providing a limited number of options.
As we have said, a cafeteria plan can offer various types of insurance policies. Many employers now ask their employees to contribute a portion of the premiums for group health, disability or term life policies. The amount of insurance premiums is generally known well in advance, which lowers the risk of an employee redirecting too much money from salaries and having to forfeit any excess. Administering of a plan based entirely on insurance—called a premium only plan (POP Plan)—is relatively simple and inexpensive. When you combine the potential tax savings created by the salary reductions with this ease of administration, the plan can quickly pay for itself. So, with only modest participation you may have found a free lunch.
Regardless of the options you provide, a cafeteria plan requires care in both implementation and ongoing administration. A well designed and well maintained plan will provide rewards, both tangible and intangible, which can make the effort worthwhile.
T. Michael Regan, C.P.A., is a partner with the accounting firm of Horovitz, Rudoy & Roteman.