More employers are turning to cafeteria plans

Flexible benefits, cafeteria plans or Section 125/129 Plans (named for the section found in the IRS code) are gaining in popularity. And employers increasingly are offering this option to employees.

They are called many things, but cafeteria plans or Section 125/129 plans are a vehicle for allowing employees to purchase various benefits with pre-tax dollars, since payroll withholding is done on a pre-tax basis.

These plans started in the early 1980s, but really gained popularity in the mid-1990s thanks to significant changes in tax law, according to Terri Mangrum, director of cafeteria plans for LBMC Retirement Plan Co., in Nashville, Tenn., a subsidiary of the Leading Edge accounting firm Lattimore Black Morgan & Cain PC.

Throughout the past 20 years, taxpayers have had fewer tax deductions and the tax code is continuously tweaked. However, the cafeteria plan offers employees an opportunity to reduce their taxable income and, consequently, their tax liability.

Section 125 plans allow you to pay for health insurance using pre-tax dollars and also allow you to set aside a specific amount of money on a pre-tax basis to pay out-of-pocket medical expenses, such as co-pays, premiums or other medical items not covered by health insurance.

"That specified amount is set aside by the employer or plan sponsor and it is a specification that is written into the plan," says Mangrum. The employee can then determine his or her individual election amount, which cannot exceed the plan's maximum.

"An employer should consider the profile of its workforce when determining a maximum amount," says Mangrum. "Since an employee's full individual election is available for reimbursement at any time throughout the plan year, the employer does have some risk. If a company experiences heavy turnover, a lower maximum amount is recommended. A professional company with a more stable workforce can elect a higher maximum amount," she says.

Section 129 plans allow employees to set aside up to $5,000 annually for dependent care expenses, which is increasingly becoming an expected benefit for employees, according to Stephen Tellez, manager in the tax department at the Leading Edge accounting firm Henry & Horne in Tempe, Ariz.

"More prospective employees think of cafeteria plan as a buzzword similar to 401(k) plans," adds Tellez.

So why don't all employers offer this benefit? "Many are not aware of these plans. They are used quite frequently in professional service firms, such as law firms, accounting firms and human resource firms, but not much otherwise," says Mangrum.

It could be simply that these plans require specific rules and regulations sanctioned by the Internal Revenue Service. More than simply guidelines, these rules and regulations must be followed and often require a third-party administrator to handle.

However, as of 2002, the IRS has made it a bit easier by eliminating the need to file Form 5500, an annual information return, which had been a required filing if participating in a Section 125 or Section 129 plan.

Money in your pocket

For every dollar set aside by an employee for a Section 125/129 plan, that employee does not have to pay FICA/Medical or federal or state withholding tax on his contributions to the plan. The employer does not have to pay the FICA/Medicare match (currently at 7.65 percent) on the employee contributions.

"Say you're an employee who earns $40,000 a year and is in the 15 percent tax bracket. If you set aside $6,000 in a Section 125/129 plans ($5,000 for childcare expenses; $1,000 for out-of-pocket medical expenses) you should save $900 per year in federal taxes. And if you pay your medical premiums (averaging $200/month) through such a plan you will save an additional $360 annually for a total of nearly $1,260 in federal tax savings," explains Mangrum.

"If you're an employer and you have 10 employees participating in the plan, paying an average of $250 per month per employee you save $2,300 annually on FICA/Medicare. Of course, you'll pick up the cost of administering the plan, which, for a small company with 10 employees is about $150 per month," she says.

Participation in a cafeteria plan will also impact reported taxable earnings. Gross earnings are reduced by the contributions to the plan; therefore, gross earnings reported on the W-2 are reduced. So taxable income that is reported on Form 1040 is less.

"More companies are beginning to realize the savings and benefits of these plans," says Tellez. "Plus they send the message to their employees that they really care about them and want to provide the best, most cost-efficient benefits for them."

There's even a Section 132 plan, which is similar to the 125/129 plans, but it allows you to pay for parking expenses, pre-tax, up to $180 per month—a great value to those who work in the city.

The only holdup to applying for Section 125, 129 and 132 plans is that the company plan must pass a discrimination test given by the third-party administrator. This test limits the amount of participation of key employees (owners or shareholders) to 25 percent. "If your company is top-heavy you're not going to pass the test. The purpose is to benefit the employees, not the employers," says Mangrum.

For example, if you add up the total amounts of money employees spend and the total amount key employees spend in the plan, the key employees portion must be less than 25 percent of the total.

The best source of information on these plans is your accountant. Many firms offer third-party benefits administration of these flexible accounts. Those who don't can likely make recommendations. Or visit www.benefitslink.com for information on cafeteria plans and links to providers throughout the nation. e