Section 125 plan: A win-win for businesses and employees
As an employer, you know that you need to offer not only competitive pay but an attractive benefits package to recruit and retain your best and brightest employees. That’s why a cafeteria plan is a must-have for any size of business. If you’re not offering one, you’re at a real disadvantage to companies that do.
No, we’re not talking about offering your employees an on-site lunch. A cafeteria plan (also known as a Section 125 plan) allows a company’s employees to benefit from tax benefits for receiving their compensation both in cash and as an employee benefit. Why is it called a cafeteria plan? Just like in a real cafeteria, where a person can choose among many different foods, employees with a cafeteria plan can select among a variety of benefits. Section 125/cafeteria plans allow employees to pay for some types of benefits with pre-tax dollars. Cafeteria plans can cover:
- Health, dental and vision insurance premiums
- Health savings accounts (HSA)
- Retirement accounts, such as 401(k)
- Group life and accident insurance plans
- Dependent care assistance
- Adoption assistance
How do they work? Under a Section 125 Cafeteria plan, for example, an employee who spends $500 a month in pretax dollars for benefits such as health insurance could save as much as $150 a month in Social Security/Medicare, federal, state and local income taxes. It really can add up!
Employers stand to save, too — hundreds of dollars a year per employee that would otherwise go to Uncle Sam in the form of the 7.65 percent of employer matching for Social Security and Medicare taxes on the pre-tax employee contributions. There is a cost for employers in starting and running a cafeteria plan, of course, but the benefits typically far exceed the investment. While you can have a cafeteria plan with as little as one employee, the more employees you have, the greater the financial benefit to your business.
There are two very common issues with businesses that offer pre-tax benefit deductions that you’ll want to avoid:
- Not Having a Written Plan: In order to offer pre-tax deductions, you MUST have a written document in place. Without the written document, you are out of compliance with IRS regulations and risk having the pre-tax deductions disallowed resulting in taxes, interest, and penalties for you and possibly your employees.
- Ineligible Employees Participating: Self-employed individuals, which include sole proprietors and partners, and more-than-2% shareholders of an S-Corp are not considered to be eligible employees and may not participate in these types of plans. Participation voids the plan for everyone, including your employees.
There are other rules you’ll need to follow in setting up and administering a cafeteria plan, and as a result, many small businesses aren’t compliant, risking issues with the IRS and costly penalties. If you use a payroll service, keep in mind that most of these companies don’t provide tax advice and can’t help your business stay compliant with Section 125 rules. A knowledgeable accounting firm can help you comply with all IRS requirements for Section 125 plans and make sure you and your employees are getting the full benefits.
