By T. Michael Regan, C.P.A.
If you hear “Flexible Spending Plans” or “Section 125 Plans,” the topic is really cafeteria plans. As its name suggests, a cafeteria plan allows an employee to select from a number of predetermined options and choose where his or her benefit dollars will be spent. The plan can provide a number of insurance 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, through payroll withholding, with pre-tax dollars.
One 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 of their future earnings into your cafeteria plan. They need to know what they get out of it and what it will cost them. Naturally such a plan allows a small business to offer benefits which would be otherwise unaffordable. Participants also receive significant tax savings.
Each employee must estimate the costs that he or she will incur during the plan’s upcoming year and have the estimated amount paid from wages into the plan. The wages withheld and paid to the plan reduce the employee’s taxable earnings for Federal, Social Security and State purposes. (Pennsylvania did not allow a tax exemption for cafeteria plan contributions until 1997)
For example, if a person in Pennsylvania 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 and State tax purposes. As a result, an individual in only the 15 percent federal tax bracket would save $453 in Federal, Social Security and Medicare taxes in addition to $56 of State tax. The reduction in take home pay would only amount to $1,491—much 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. In this latter case, the $1,491 cost must be compared to the amount that the person would need to earn to net the $2000 necessary to pay for the medical expenses. For someone in a 15 percent-tax bracket, that amount is $2,680.
Again, staff education about cafeteria plans must explain both the positive and negative aspects 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 following pitfalls. 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 childcare 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 until the end of the plan year, except under specific circumstances, such as changes in marital status, number of dependents or a spouse’s employment. And, any funds unused by the end of the plan year are not refundable and will be forfeited by the participant. Participant counseling should emphasize the need to make an accurate estimate 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 childcare. 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 the 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 by the employer. 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 direct $100 per month into a plan. The annual payroll tax savings for the employer would exceed $1100.
What about any downside potential for the employer? Cafeteria plans share certain administrative hassles and formalities with retirement plans. For example, the plan must be in writing and filed with the Department of Labor. 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. For instance, no more than 25 percent of the plan’s benefits can be paid on behalf of key employees. Any benefits received by the highly compensated group from a discriminatory plan become taxable to them. The plan must also file an annual tax return, Form 5500. Although this 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. There is no bonding requirement as there is with retirement plans. Finally, relatively simple plans can be economically effective while offering a limited number of options.
As we have said, a cafeteria plan may 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 directing too much money from salaries and having to forfeit any excess. As a matter of fact, the plan can specify that the employee contribution can be adjusted to accommodate changes in the premiums. Administering a plan based entirely on insurance—called a premium only plan (POP Plan)—is relatively simple and inexpensive. When you measure the potential tax savings created by the salary reductions against the related costs, the plan can easily pay for itself.
Regardless of the options you provide, a cafeteria plan requires care in both implementation and ongoing administration. A properly designed and 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.