There are many ways employers can provide benefits to employees and not all require a Section 125 Cafeteria Plan. But if an employer wants to enable employees to contribute part of their salary to a qualified spending account like a Health Savings Account (HSA) or Flexible Spending Arrangement (FSA), and/or if the employer wants to make contributions to said employee accounts, they should maintain this document.
It is possible for employers to make direct contributions to employees’ accounts outside of a Section 125 Plan, but the rules that govern these types of contributions are strict and carry a hefty penalty if they’re not followed. Specifically, any contributions not made through a Sec 125 are subject to strict comparability rules. Employer contributions made through a Sec 125 plan are not subject to the comparability rules, but are subject to non-discrimination rules.
What is a Section 125 Plan?
A Section 125 Cafeteria Plan is a written document maintained by an employer that outlines the rules which allow employees to make tax-free contributions to qualified benefits accounts like HSAs. It must describe in detail the benefits the cafeteria plan offers, who is eligible to receive said benefits, and other rules about how the plan operates. It must include a taxable benefit (i.e. compensation) that’s exchanged for a non-taxable benefit (e.g. contributions to an HSA).
If the employer wants to contribute to employees’ accounts, those contribution rules should be outlined in the cafeteria plan as well. Employers can make direct contributions to employees’ accounts without a cafeteria plan, but if they choose to do this, they’re required to give every employee either the exact same dollar amount or the same percentage of their health plan deductible. If the employer doesn’t follow this equitability rule, they could be subject to a 35% tax.
Since a Section 125 Cafeteria plan allows employers to set their own rules for contributions (as long as they don’t run afoul of the anti-discrimination rules described later), it’s a better way for them to contribute to employees’ accounts.
Rules for cafeteria plans include:
Rule #1- Eligible benefits under a Section 125 Cafeteria Plan
An employer’s cafeteria plan may cover one or multiple of the following benefits:
- Health Reimbursement Arrangements (HRAs)
- Dependent Reimbursement Account (DRA)
- Premium Only Plans (POPs)
- Adoption Assistance
- Accident and Health benefits (excluding Archer Medical Savings Accounts (MSAs) or long-term care)
- Group term life insurance
Rule #2- Who is eligible to receive benefits under a Section 125 Cafeteria Plan
The benefits described in the plan must be made equally available to employees in the same situation, their spouses and dependents. Employers may also choose to include domestic partners and their dependents in those eligible to receive benefits.
The employer can choose to make rules about eligibility that relate to:
- Employee start date
- Employee participation (i.e. employee must elect to participate in the plan)
- Employee classification (e.g. part-time vs. full time)
- Employees under a collective bargaining agreement
- Employee waiting periods
- Employees under age 25
- Foreign employees working abroad with no US income
- Geographic location/ rating area
- Special enrollment periods
- When individuals can change their plan selections
- How individuals can terminate plans
- Any combination of the above
The IRS prohibits discriminating against plan participants and beneficiaries based on health factors. That means a plan cannot restrict eligibility based on:
- Health factors (e.g. health status, medical condition, disability, genetic information, etc.)
- Evidence of insurability (e.g. engaging in high-risk adrenaline sports)
Rule #3- Who can participate in a Section 125 Plan based on company type
- All eligible employees (as described in the plan document) of regular corporations, S-corporations, limited liability companies (LLCs), partnerships, sole proprietorships, professional corporations and nonprofits.
- Anyone owning 2% or less of an S-corporation.
Rule #4- Who is excluded from participating directly in a Section 125 Plan based on company type
- Sole proprietorships: the Sole Proprietor.
- Partnerships: the partners.
- S-corporations: any individual owning more than 2% of the company.
- LLCs: members.
How do these plans work?
When an employee agrees to participate in the cafeteria plan, they select the benefit(s) and the amount they wish to contribute, then the employer subtracts the appropriate amount from each paycheck and deposits it into the selected account(s).
How do the taxes work?
The general rule for Section 125 plans is: the contributions are tax-free. That means employees’ contributions aren’t subject to FICA, FUTA, Medicare tax or income tax withholding. However, our tax code is complex and there are many forms of “taxes”. And contributions to different benefit accounts are subject to different tax rules. For the complete set of tax rules for different benefits accounts, refer to the IRS Employers’ Tax Guide and Supplemental Tax Guide. Here are the basics:
- Contributions to group term life insurance policies that exceed $50,000 in coverage are subject to: Social Security and Medicare taxes.
- Contributions to adoption assistance plans are subject to: Social Security, Medicare and FUTA taxes.
Employers also receive tax benefits from allowing employees to access benefits through a Section 125 Plan. When employees make contributions to accounts like HSAs, employers don’t pay the matching Social Security, Medicare and FUTA taxes on said contributions. Employers also receive tax breaks on contributions they make to employees’ accounts on the employees’ behalf.
If an employer offers a Section 125 Cafeteria Plan, there’s no need for it to file additional paperwork with the IRS. The exception is if it offers a welfare plan. If an employer offers a welfare plan, it may need to file a return for that plan.
By setting up a Section 125 Cafeteria Plan, employers give themselves the flexibility to offer benefits like HSAs and FSAs and set the eligibility and contribution rules that make sense for their company. It also enables employers to reap greater tax benefits and support the health and well being of their workforce all at the same time.
Disclaimer: the content presented in this article are for informational purposes only, and is not, and must not be considered tax, investment, legal, accounting or financial planning advice, nor a recommendation as to a specific course of action. Investors should consult all available information, including fund prospectuses, and consult with appropriate tax, investment, accounting, legal, and accounting professionals, as appropriate, before making any investment or utilizing any financial planning strategy.