Click to Print

The Benefits of Cafeteria Plans

Start maximizing your employee benefits package--and saving money--with a section 125 flexible benefits plan.
September 14, 2005
URL: http://www.entrepreneur.com/article/79978

One of the most underrated and underused employee benefits available for small businesses today is outlined in section 125 of the U.S. tax code. A section 125 or "cafeteria" plan allows employees to withhold a portion of their pre-tax salary to cover certain medical or child-care expenses. Because these benefits are free from federal and state income taxes, an employee's taxable income is reduced, which increases the percentage of their take-home pay. And because the pre-tax benefits aren't subject to federal social security withholding taxes, employers win by not having to pay FICA--or workers' comp premiums--on those dollars.

With so many advantages, why is the plan underused? The most likely reason is that these plans don't generate a lot of profit for benefit administration companies, and with little profits to earn, only minimal advertising is being done. That means many people are unaware the plan even exists. But utilizing the tax code for your business can be an incredible way to enhance your employee benefits package, while simultaneously boosting your margins.

Under a cafeteria plan, your employees can take advantage of three specific flexible benefits:

1. Pre-tax health insurance premium deductions, also known as a Premium Only Plan (POP). POP plans allow employees to elect to withhold a portion of their pre-tax salary to pay for their premium contribution for most employer-sponsored health and welfare benefit plans. The plan offers a simple way to obtain favorable tax treatment for benefits already offered. Most companies currently have this set up through their payroll provider. A POP plan is the simplest type of Section 125 plan and requires little maintenance once it's been set up through your payroll.

2. Out-of-pocket unreimbursed medical expenses, also known as flexible spending accounts (FSAs). An FSA allows an employee to fund certain medical expenses on a pre-taxed basis through salary reduction to pay for out-of-pocket expenses that aren't covered by insurance (for example, annual deductibles, office co-payments, prescriptions, over-the-counter drugs and orthodontia). The average working employee in America spends more than $1,000 annually on these types of benefits. By participating in a FSA, an employee's taxable income is reduced, which increases the percentage of pay they take home.

3. Dependent care flexible spending accounts. The dependent care FSA is an attractive benefit for employees who pay for child-care or long-term care for their parents. Many employees don't take advantage of this benefit and may be unaware of the significant tax savings. Employees may hold back as much as $5,000 annually of their pre-tax salary for dependent care expenses, which include expenses they pay while they work, look for work or attend school full time. Qualified dependent care expenses may include--but are not limited to--the care of a child under the age of 13, long-term care for parents, care for a disabled spouse or a dependent incapable of caring for himself, and summer day camps. In addition, by paying for dependent care with pre-tax dollars, your employees can save approximately 20 to 40 percent on their child-care expenses.

The best part about the Section 125 plan is that most of your employees are already paying for these expenses out of their own pockets with after-tax dollars. Cafeteria plans offer them a remarkable way to save money they're already spending.

Here's how it works:

So what are the benefits to you as the employer?

And what are the benefits to your employees?

There are several administrative procedures that must be met to comply with Section 125 code legal requirements.

1. A plan document must be established. This document outlines specific details, such as a description of the employee benefits that are covered through the plan, participation rules, annual limits, election procedures, eligibility and employer contribution. It also defines the plan year.

2. A summary plan description (SPD) must be distributed to all participants. Section 104(b) of the Employee Retirement Income Securities Act of 1974 (ERISA), the basic law designed to protect the rights of participants and beneficiaries of employee benefit plans, requires that an SPD must be distributed to all participants no more than 90 days after an employee becomes a participant or within 120 days of the plan becoming subject to ERISA. A participant's beneficiary must also receive the summary plan description within 90 days after becoming eligible for benefits. The SPD summarizes specific details of the plan, claim filing procedures, and information concerning plan sponsorship and administration. In addition to distributing it to your employees and their beneficiaries, you must also file it with the Department of Labor within 120 days of the plan's effective date.

3. There's ongoing compliance that must be attended to. The laws are constantly changing and being updated. Federal legislation requires that section 125 plans can't discriminate as to eligibility and benefits being provided. Failure to meet the nondiscrimination requirements would eliminate the tax-free status of the benefits provided to the highly compensated and/or the key employees.

One of the best benefits for business owners is that cafeteria plans cost very little to set up and maintain. For most employers, the cost of implementing the plan is recovered through tax savings during the first year--you might even begin saving money as early as the month following the installation of a POP plan. So what are you waiting for? Now's the time to act--to benefit your employees and your business.


Trent D. Bryson, CFP, is president of Bryson Financial Group, an employee benefits consulting company in Long Beach, California, that works with companies regionally and nationally regarding their employee benefit needs.