How You and Your Employees Can Maximize Tax Savings
On today’s episode of Healthcare Simplified we are extremely lucky to have, for the third time, employee compliance benefits extraordinaire, Sandy Krauer. She’s back, and this time, Sandy’s here to talk about how you can maximize tax savings by implementing a Section 125 Cafeteria Plan.
Update from the last podcast Sandy was on
On the last podcast, Sandy brought up that there were going to be proposed changes to the FLSA Act’s overtime provisions and exemptions for the minimum salary rate. Last month, the department of labor released several notices of proposed rule making changes.
These proposed changes include a change to the salary test requirement. In 2016, the initial proposed changed would have double the minimum salary per week threshold, but it failed to pass. This new attempt to implement change to this rule would increase the minimum weekly salary threshold from $455 per week to $679 per week.
This is the initial notice of a proposed change to the Act. Once the notice is published in the Federal Register, the public then has 60 days to post their comments and give their input on the changes. Then there will be another 60-day period to finalize the changes before it would become final.
The benefit of implementing a Section 125 Cafeteria Plan
The Section 125 Cafeteria Plan is based on the Federal tax code Section 125 regulations. It is a program that takes advantage of an allowed exception to the federal tax code that enables employees to pay their portion of certain employer provided insurance benefits or other qualified benefit program with pre-tax dollars from their paycheck. Qualified benefits include health, vision and dental insurance premiums, contributions to an HSA, FSA, and dependent care assistance program.
Overall, this benefit program creates a tax savings to both the employer and the employee. This is because federal tax code provides that wages and benefits received by employees from their employers are taxable unless they fall within an exception to the tax code. A Section 125 Plan creates this approved exception without creating any issue of constructive receipt. Under a Section 125 Plan, employees may use some of their wages to pay for certain benefit programs before the money is paid to them as salary and taxed. For an employer, this means that they would not have to pay payroll tax (FICA, FUTA) on the employee wages applied to Section 125 benefits. For an employee, that money will be exempt from federal income tax withholding and their portion of FICA, and, generally, state income tax withholding. There are even some states that treat the cafeteria plan favorably for state and local income tax as well as unemployment tax and workers comp tax.
Why wouldn’t an employer offer benefits under a Section 125 Plan?
Some small employers may not offer this benefit plan because they may have problems passing the required nondiscrimination testing – simply because of number of employees not because of unfair practices. However, they may be able to offer a “Safe Harbor” Plan, if they are willing to meet certain employer contribution requirements.
Others may think they are offering a valid plan but, are not performing some or all of the requirements such as having a written plan document, or not performing the annual plan nondiscrimination tests, so their plan is not considered a valid plan.
The 3 Types of Cafeteria Plans
There are 3 basic types of Section 125/Cafeteria Plan:
Basic Salary Reduction Plan
Allows employees to pay their contributions of premiums to the employer sponsored insurance benefit such as health, vision, and dental insurance and can also include contributions to an HSA through salary reduction.
Component Benefits Plan
This plan only offers component benefits such as Health FSA, and dependent care assistance programs.
Full Cafeteria Plan
This plan incorporates all of the benefit components: salary reduction premium contributions and flexible spending arrangements.
A valid Section 125 Cafeteria Plan
Our government loves to collect their taxes, so if they are going to allow you to take some tax favored advantages then they are going to make you jump through some hoops.
You must first have a written plan document that incorporates all of the operating rules under your Section 125 Plan. This document would include information like the Plan Year (any consecutive 12-month period), what benefits will be offered, who is eligible and who isn’t, when participants can make elections, and if they can make elections during the plan year.
The plan must be adopted by the employer before the employees can start taking advantage of the plan and start making contributions.
Employees must be provided with written communications regarding the plan rules, regulations, and benefits.
Employees must then elect to participate by completing some sort of written election form.
You must then make sure that the whole point of the plan is to provide benefits to your rank and file employees. This means you must make sure you aren’t providing more benefits to your highly compensated employees than your rank and file employees.
You must conduct, and pass, the annual Non-Discrimination testing to prove you are actually complying with the regulations.
Lastly you need to make sure that you are doing all of the administration things and following all of the terms of your plan document.
The purpose of this annual plan testing requirement is to ensure that the Plan does not provide a greater benefit in plan design and operation to the HCE group. HCEs are defined in a number of ways depending on the nondiscrimination provisions of the various applicable tax code sections. But, for the purposes of Section 125 Plan testing, in general terms, an HCE would include any officer of the organization, certain percentage shareholders depending on entity type, employees with earnings of at least $120,000 in the previous year and certain spouse/children/parent employees of the preceding groups. The annual nondiscrimination testing must be completed each year before the end of the plan year, but it is a good idea to do a mid-year test to make sure there won’t be any testing issues and to allow time to make any plan corrections before the Plan Year ends.
There are 3 tests for the basic Salary Reduction Plan: the eligibility test, the contribution and benefits test, and the 25% key employee test. Note that in addition to the basic Section 125 tests, each component benefit, such as the Health FSA and Dependent Care Assistance Program, has their own testing requirements so this could add up to about 12 tests in total to conduct each year to ensure that your Plan remains in compliance.
Each test incorporates certain math ratios to weigh HCE benefits and utilization against the same for rank and file employees. This makes it difficult often for small employers to pass because the ratios may be skewed just because of the employee size of the employer. if for example, one HCE taking full advantage of the benefits in a very small employer group, or if there is high HCE participation and overall low participation by rank and file employees (non-HCEs), this can drastically affect the numbers for testing ratios. Luckily, there is a safe harbor Plan available to small employers with less than 100 employees to help alleviate this issue and enable the small employer to offer this tax-saving benefit.
Any other challenges employers may face when implementing this plan
One main challenge that might occur is knowing who is eligible to participate. The Cafeteria Plan is designed for only employees to participate. This means that depending on the type of company, owners may not be able to participate and even the spouse, parent or children-employees of the owner may be ineligible.
If you have any questions you’d like to ask Sandy, send us an email at firstname.lastname@example.org.
This post is based on a podcast interview with Sandy Krauer from Total Focus HR Solutions.