Get to know the history, benefits and answers to the most common questions
Introduced under the Revenue Act of 1978, this piece of legislation introduced what are known as cafeteria plans (sometimes referred to as wellness plans) under Section 125. These plans provide for tax benefits for business owners and employees alike. The underlying intention was to help employers make benefit plans more widely available.
Origins:
The cafeteria plan rules under the Internal Revenue Code (IRC) provide guidelines for cafeteria plans, which allow employees to choose from a menu of benefits.
These benefits can include health insurance, flexible spending accounts (FSAs), dependent care assistance, and other nontaxable options.
The goal of Section 125 was to create a tax-advantaged way for employees to customize their benefits package according to their needs.
1984 Amendments:
In 1984, significant amendments were made to Section 125.
These amendments clarified the rules for cafeteria plans and their tax treatment.
The key provisions included:
Nondiscrimination Requirements: Cafeteria plans had to be nondiscriminatory, meaning they couldn’t favor highly compensated employees.
Qualified Benefits: The types of benefits that could be offered through cafeteria plans were specified.
Tax Treatment: Employees’ contributions to cafeteria plans were made on a pretax basis, reducing their taxable income.
Employer Contributions: Employers could contribute to cafeteria plans as well.
Third-Party Administrators: The role of third-party administrators in managing cafeteria plans was addressed.
Subsequent Developments:
Over the years, additional regulations and guidance have been issued by the IRS to further refine the rules governing cafeteria plans.
These regulations address issues related to eligibility, plan design, and compliance.
The goal has always been to strike a balance between providing flexibility to employees and preventing abuse of the tax advantages.
In summary, Section 125 has evolved over time to facilitate flexible benefit offerings while ensuring fairness and compliance.
Plan Benefits
Benefits to Employees:
Participants in a Section 125 plan can save money by setting aside insurance premiums and other funds pretax.
These funds can then be used for qualified medical expenses and child care costs.
Depending on their location, participating employees can save from 20% to 40% in combined federal, state, and local taxes on eligible expenses they typically purchase with out-of-pocket post-tax funds.
Benefits to Employers:
Employers save on various taxes, including:
Federal Insurance Contributions Act (FICA) tax: This tax funds Social Security and Medicare.
Federal Unemployment Tax Act (FUTA) tax: This tax funds the federal unemployment insurance program.
State Unemployment Tax Act (SUTA) tax: This tax supports state unemployment benefits.
Workers’ compensation insurance premiums: Employers save on these premiums for each participant in the plan.
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A Section 125 plan allows employees to convert taxable benefits (such as cash salary) into nontaxable benefits.
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Employees can set aside a portion of their salary on a pretax basis to pay for qualified benefits. This portion is not considered wages for federal income tax purposes.
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The plan can be made available to employees, their spouses, and their dependents. Former employees may also have access, but the plan cannot exist primarily for them.
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Statutory Requirements:
- Section 125 of the IRS Tax Code allows employers to offer cafeteria plans.
- Employees must be allowed to choose between taxable cash compensation and certain qualified benefits on a pre-tax basis.
Regulatory Requirements (26 CFR § 1.125-1):
- Plan must be in writing and communicated to employees.
- Plan must offer employees the choice between cash and qualified benefits.
- Elections must be made before the start of the plan year.
- Plan must not discriminate in favor of highly compensated employees.
- Plan must comply with other IRS regulations regarding cafeteria plans.
In simpler terms, employers must have a written plan that lets employees choose between cash and certain benefits before the plan year starts. The plan must treat all employees fairly and follow IRS rules.
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