What Is A Cafeteria Plan?
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Reduce Taxes with a
Section 125 Cafeteria Plan

What is a Section 125 Cafeteria Plan?

Section 125 Plans are called by a variety of names: pretax plans, cafeteria plans, salary reduction plans, and salary redirection plans. But all these names refer to plans designed to reduce taxes for employers and their employees under Section 125 of the Internal Revenue Code.

Section 125 permits employees to pay for certain benefits before taxes through pre-tax deductions from their paychecks. These pre-tax deductions have the effect of lowering the employee's taxable income. Consequently, the employee pays less in FICA and Federal Withholding taxes. Most employer sponsored insurance plans qualify to be "pre-taxed." This includes employee-paid costs for medical insurance, dental insurance, group term life insurance and a variety of others. In addition, dependent-care expenses (usually child-care) and many kinds of vision, dental and medical expenses can be "pre-taxed."

Also, since the employer's portion of FICA is calculated based upon the employee's taxable earnings, the company will reduce its FICA tax liability by 7.65% of every employee dollar that is deducted before taxes. The employees' total tax-savings will usually range from 17.65% to 46.25% (marginal tax rate + FICA). Most employees fall into either the 22.65% or 32.65% category. This mean that every dollar "pre-taxed" will save an employee in the 27% marginal tax rate about 33 cents (25% + 7.65%).

This is not a temporary saving which must be repaid at the end of the year when the tax return is filed. For both the employer and the employee, it represents permanent tax-savings (a true win-win).

The law requires that certain documents be put in place to set up and operate a Section 125 Cafeteria Plan. These include the Plan Document (kept up to date with changes in the law), Summary Plan Description, (where necessary) a properly executed Salary Reduction Agreement on each participant and (depending upon the group size and nature of the plan) preparation of the annual Form 5500. In addition, annual compliance testing must be performed to make sure the plan is not top-heavy (a maximum of 25% of contributions under the plan can come from owners and other "highly compensated" employees).

Since most payroll services and payroll software packages now make it easy to pretax insurance premiums, many employers, unaware of these requirements, simply begin making pretax deductions from their employees' paychecks without having ever properly set up a plan. The IRS penalties for doing this can be severe. The good news is that we can offer professional services to insure that you stay in compliance and never incur any penalties.

Two Types of section 125 Cafeteria Plans: POPs & FSAs

Premium Only Plans (POPs)

There are two types of Section 125 Cafeteria Plans. Premium only Cafeteria Plans (usually called "POPs") are designed to reduce taxes on insurance premiums only. The portion of the premiums paid by the employee can be pre-taxed under the plan. Most insurance premiums qualify. For many groups, setting up a POP is all that is required for both the company and its employees to realize substantial tax-savings.

It is important to make sure your plan is in compliance with IRS regulations, because noncompliance can result in heavy IRS fines. We can furnish a qualified POP plan to the employer and keep the plan current for a modest cost. In many cases, that modest fee can be reduced to zero by taking advantage of a voluntary employee benefit portfolio.

Other sources of POP Plans are available. CPA and law firms can often offer POP plans, but the cost is generally high. The only consistently high quality administration available at an affordable price will probably be through a professional Third Party Administrator.

How Pop Plans work: An Example

Let's look at an example in which an employ making $3,000 per month pays insurance premiums in the amount of 500 per month. The first column illustrates how the employee's take - home pay is calculated if there is no Section 125 Pop Plan. Thos. the second column shows the tax- saving effect of implementing a Section Pop Plan.

Gross Monthly Pay
$ 3,000.00
$ 3,000.00
Pre-Tax Insurance Premiums

Taxable Income
Federal Withholding Tax*
FICA Tax(Soc.+ Medicare)
After-Tax Insurance Premiums

Spendable Income
Tax-Savings to Employee: $161.25 per Month ($1,935.00 per Year*)

Tax-Savings to Company: $38.25 per Month ($459.00 per Year)

(*Based on W-4 Withholding Allowance Status: S-0. Source: IRS Publication 15-T (rev. June 2003))

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