For business owners, identifying ways to provide fringe benefits to attract and retain employees has become more crucial than ever. In this era of low unemployment rates, having a competitive advantage in the labor market can be difficult. This will, in turn, impact a business’ ability to recruit and retain qualified employees and keep operations running smoothly. However, companies offering competitive employee benefits can give themselves an advantage. When considering what benefit plans to offer, you may want to consider Section 125 plans.
125 is part of the IRS Code that allows employees to convert a taxable cash fringe benefit (salary) into non-taxable benefits. Under a Section 125 program you may choose to pay for qualified benefit premiums before any taxes are deducted from employee paychecks. This is often referred to as a “pre-tax” benefit.
The three basic forms of Section 125 plans are:
- Premium Only Plan
- Flexible Spending Accounts
- Full Cafeteria Plan
The Premium Only Plan (POP) is the most basic type of Section 125 plan and the most popular. A POP allows employees to pay their portion of insurance premiums with pre-tax dollars, which in turn reduces both the employer’s and employees’ tax liability. The most common benefits normally offered within a POP include: health, dental, vision, accidental death and dismemberment, and group term life insurance.
Under IRC Section 125, employees may make pre-tax contributions to a Flexible Spending Account (FSA). The employee funds their FSA with “pre-tax” dollars withheld from their wages. Annually, the employee makes an election for the amount they want to contribute to their FSA. Then throughout the year, the employee requests reimbursement from their FSA for expenses paid for child care, health plan deductibles and eligible medical expenses, not otherwise covered under a health plan. An FSA allows an employee to increase his or her spendable income, by reducing taxable wages, while also reducing the employer’s tax liability
A Full Cafeteria Plan (FCP) allows the employer to make a non-elective contribution for every eligible employee. The employees may spend the employer’s contributed funds to purchase any of the benefits offered within the Cafeteria Plan. The employer determines what benefits are “on the menu” for the Cafeteria Plan. In addition, the employee may also contribute pre-tax dollars from their wages to purchase additional benefits beyond what he or she can purchase with the employer’s contribution.
There are some disadvantages of Section 125 plans that should also be considered.
- Once the employee makes the annual elections for participation, changes can’t be made unless there is a qualifying “life event” that occurs (marriage, divorce, birth of a child, etc.).
- Any unused dollar amount remaining within an FSA at the end of the year (including grace periods) is lost. This is referred to as “use it or lose it”.
- While a Section 125 plan reduces the employee’s taxable income, it also may reduce other benefits. Common benefits that are calculated using the employee’s income, and therefore reduced are, social security and retirement benefits. It is important the employee weigh the current benefit of reduced income taxes with loss of other benefits.
- The employer will incur some cost for establishing and maintaining these plans. Various third-party vendors offer this service and the fees normally include a fixed fee, plus a per enrolled employee charge. This cost should be compared with the payroll tax savings and value provided for workforce attraction.
- Employers that offer a health FSA do bear some risk of loss. They are required to provide the full, annual amount elected by the employee at any time during the year. This means a health reimbursement requested by an employee may have to be paid in full prior to the employee fully funding their elected amount through payroll deductions.
These types of plans have been available for many years. However, there have been some changes to the offerings as a result of the Affordable Care Act passed in 2010. It is important to review your fringe benefit offerings with a qualified benefits expert to make sure they comply with current . Call TDT CPAs and Advisors for referral to a qualified benefits professional.
Jodi Kerr, CPA is a tax partner with over 30 years of experience serving the income tax and consulting needs of individuals and small businesses.