- Sole proprietors, partners, over 2% S-corp shareholders, and independent contractors cannot participate in cafeteria plans.
- Cafeteria plans must offer at least one taxable salary benefit and one pre-tax qualified benefit.
- Ineligible benefits include long-term care, athletic/fitness facilities, deferred comp, stock options, meals & lodging.
- Benefits like health insurance, FSA/HSA contributions, retirement plans can be offered pre-tax.
- Employees can choose cash or taxable benefits if they don’t want the pre-tax options.
What is a cafeteria plan and what are its benefits??
A cafeteria plan, also known as a Section 125 plan, allows employees to choose from a menu of different benefit options offered by their employer. The plan offers benefits on a pre-tax basis, so employees can save money on taxes. Some key advantages of cafeteria plans include:
- Pre-tax savings – Employees can pay for benefits pre-tax, reducing taxable income. This increases take-home pay.
- Flexibility – Employees can customize benefits to fit their needs from the options provided.
- Variety – Cafeteria plans offer benefits beyond just healthcare. Things like FSAs, life insurance, retirement plans may be included.
- Reimbursement accounts – Employees can set aside pre-tax money in FSAs for healthcare or child/dependent care expenses.
- Control – Employees can select the optimal benefits for their personal situation.
So cafeteria plans provide tax savings, flexibility, and control for employees to get the right mix of benefits.
What are the IRS rules for cafeteria plan eligibility and participation?
The IRS has guidelines on who is eligible to participate in a cafeteria plan:
- Employees – Full-time and part-time employees can participate. Union employees may be eligible too.
- Business owners – Sole proprietors, partners, and over 2% S-corp shareholders cannot participate.
- Independent contractors – Independent contractors are also ineligible per the IRS.
Additionally, the IRS requires cafeteria plans to meet certain criteria:
- There must be at least one taxable cash benefit option considered part of salary.
- There must be at least one qualified pre-tax benefit offered.
- Participants must be able to choose between 2 or more benefits.
- Annual open enrollment and changes in status allow election modifications.
Adhering to these IRS rules is key for cafeteria plan compliance and maintenance of tax advantages.
What benefits are not eligible for cafeteria plans under Section 125?
While cafeteria plans offer extensive options, there are some benefits the IRS prohibits from being offered pre-tax:
- Long-term care insurance – This must be offered as taxable benefit.
- Athletic/fitness facilities – Gym membership or fitness programs don’t qualify.
- Deferred compensation – Non-qualified deferred compensation is ineligible.
- Stock options – These must be taxable when exercised.
- Meals and lodging – Providing meals or housing is not allowed pre-tax.
- Educational assistance – Must be taxable benefit under Section 127.
- Group term life insurance – Premiums above $50,000 are taxable.
- Non-insurance benefits – Things like vacation days, sick leave, discounts don’t qualify.
So cafeteria plans cannot offer these types of benefits on a pre-tax basis per IRS guidelines. They must be offered as taxable benefits only.
What benefits can be offered pre-tax under a cafeteria plan?
The most common pre-tax benefits offered through cafeteria plans include:
- Health insurance premiums – Premiums for medical, dental, vision can be paid pre-tax.
- FSA/HSA contributions – Funds put in a healthcare or dependent care FSA reduce taxable pay.
- Group term life insurance – Up to $50,000 in coverage can be pre-tax.
- 401(k)/403(b) contributions – Pre-tax retirement plan contributions.
- Disability insurance premiums – Premiums for disability policies can be pre-tax.
- Adoption assistance – Provides pre-tax reimbursement for eligible adoption expenses.
Offering these types of benefits pre-tax allows employees to save on taxes. Cafeteria plans optimize take-home pay by reducing taxable income.
What options do employees have if they don’t want the pre-tax benefits?
For employees who don’t want to participate in the pre-tax qualified benefits, cafeteria plans may offer taxable benefit choices like:
- Cash – Employees may take taxable cash as part of their salary.
- Supplemental life insurance – Additional life insurance may be elected as a taxable benefit.
- Disability insurance – Disability coverage beyond the pre-tax limit can be taxable.
- Dependent care FSA – Can be offered as taxable benefit if pre-tax limit is met.
- 401(k) contributions – Elective deferrals over the pre-tax limit would be after-tax.
- Other voluntary benefits – Things like accident, cancer, critical illness offered as taxable benefits.
Offering taxable benefit options caters to employees who don’t need or want the pre-tax cafeteria plan benefits.
What are the key steps for implementing and administering a cafeteria plan?
There are some important steps employers should take when establishing and running a cafeteria plan:
- Consult with counsel/advisors to ensure compliance with regulations.
- Draft a written cafeteria plan document that outlines all rules and provisions.
- Obtain board approval and adopt the cafeteria plan.
- Select tax-advantaged benefits and taxable options to offer under the plan.
- Review and update plan annually based on changes to laws, benefits, or company goals.
- Communicate details of plan to employees and conduct open enrollment.
- Administer flexible spending accounts, handle enrollment, monitor limits, process claims.
- Arrange for COBRA administration if health FSAs are offered.
- File Form 5500 annually for cafeteria plans once they reach 100 participants.
- Ensure compliance with non-discrimination rules by doing testing.
Following best practices for implementation, communication, and administration ensures a compliant cafeteria plan.
What are the non-discrimination requirements applicable to cafeteria plans?
To prevent discrimination in favor of highly compensated employees, cafeteria plans must pass certain IRS tests:
- Eligibility test – The plan’s eligibility terms must not discriminate in favor of highly compensated individuals.
- Benefits test – The benefits provided under the plan must be available to all eligible employees.
- Key employee concentration test – No more than 25% of the total benefits can go to key employees.
- 5500 participants test – Once a plan covers over 100 participants, Form 5500 must be filed annually.
Failing any of these non-discrimination tests results in highly compensated employees losing their tax benefits until issues are corrected. Employers should do periodic testing to ensure compliance.
How can employers optimize their cafeteria plan offerings and use?
Some tips for employers to optimize their cafeteria plan include:
- Survey employees to find out what benefits they value most.
- Offer a wide array of benefit options catered to diverse needs.
- Set employee contributions no higher than 10-15% of premiums.
- Consider wellness incentives/rewards for participation and hitting targets.
- Communicate plan details through multiple channels and media.
- Provide cafeteria plan decision tools to help with benefit selections.
- Analyze utilization data to modify future plan offerings accordingly.
- Ensure all health FSAs are COBRA-eligible to maximize participation.
- Add retirement savings options like 401(k)s with matching contributions.
Taking these steps can boost cafeteria plan engagement and usage among employees.
What are the tax implications of participating in a cafeteria plan?
The main tax benefit of participating in a cafeteria plan is being able to purchase benefits pre-tax. Key tax implications include:
- Employee contributions to pre-tax options are not subject to federal, FICA, or state income taxes.
- Employer contributions are a deductible business expense and not taxable income to employee.
- Certain taxable benefits like educational assistance or group term life insurance get preferential tax treatment.
- Cafeteria plans must pass non-discrimination tests to ensure tax benefits are not skewed to highly compensated.
- Employees can only make election changes after open enrollment due to IRS change in status rules.
- Employees forfeit unused FSA balances at year-end per the use-it-or-lose-it provision.
Understanding the tax advantages and implications helps employees optimize their cafeteria plan decisions.
What are some examples of change in status qualifying events for election modifications?
According to the IRS, the following are change in status events allowing employees to modify their cafeteria plan elections mid-year:
- Marital status changes due to marriage, divorce, death, legal separation.
- Number of dependents changes due to birth, adoption, death, gaining/losing custody.
- Employment status changes due to starting/ending employment, unpaid leave, FMLA leave.
- Dependent eligibility changes due to exceeding age limit, gaining/losing student status.
- Residence changes resulting in gain/loss of eligibility.
- Loss of coverage under another employer plan.
- Court orders mandating coverage changes for dependents.
Employees must notify their employer within 30 days of a qualified change event to alter elections accordingly. Plan sponsors should ensure they adhere to IRS regulations for election change procedures.
What compliance considerations should employers be mindful of?
Key cafeteria plan compliance issues employers should monitor include:
- Ensure eligibility and participation rules adhere to IRS non-discrimination tests.
- Offer at least one taxable benefit considered part of employee salary.
- Include one or more IRS qualified pre-tax benefits in the plan.
- Follow change in election procedures properly according to IRS rules.
- Don’t allow improper mid-year election changes or benefits trading.
- Test reimbursements for FSAs to confirm they are for eligible expenses only.
- File Form 5500 once over 100 participants or follow limited excepted reporting.
- Review documents annually and update for any regulatory or benefit changes.
- Communicate plan modifications to employees in a timely manner.
Remaining compliant is crucial to preserve the tax advantages of cafeteria plans for both employers and employees.
What are the risks if an organization does not comply with Section 125 plan rules?
Here are some potential consequences if an employer fails to comply with IRS cafeteria plan regulations:
- All participants may lose the tax benefits for the plan and have to pay back taxes and penalties.
- Plan may be disqualified by IRS for not operating legally per Section 125.
- Highly compensated employees may have taxable income from excess pre-tax benefits.
- Employees may make disallowed mid-year election changes resulting in tax issues.
- Employer may face penalties, back taxes, and interest if payroll taxes weren’t properly withheld.
- Employees may forfeit tax savings on ineligible reimbursements made from flexible spending accounts.
- Reimbursements of non-qualified medical expenses from an FSA are taxable to employee.
These outcomes demonstrate the importance of cafeteria plan compliance for both employers and employees.
While cafeteria plans offer extensive tax-saving benefit options, there are restrictions on which benefits can be offered pre-tax. Employers must follow IRS rules regarding eligible benefits, non-discrimination tests, and election change procedures to ensure their cafeteria plan meets requirements. Staying compliant preserves the plan’s tax advantages. With sound oversight and administration, employers can optimize their cafeteria plan as an attractive recruiting and retention tool. Employees also benefit from the flexibility to tailor their benefits package and the ability to pay premiums and fund accounts pre-tax. Overall, cafeteria plans provide advantages to both employers and employees when implemented mindfully and monitored diligently