An employer can set up a Cafeteria Plan to reimburse employees for selected medical expenses. These plans are pre-tax benefits for employees and may include:
Flexible Spending Accounts
Dependent Care Assistance Programs
Adoption Assistance Programs
Premium Conversion Plans
A cafeteria plan is a program that employers offer to help employees pay for certain expenses (like health insurance and dependent care) with pre-tax dollars. Employees get to select which benefits they really want (like ordering a lunch item à la carte instead of being stuck with the full meal combo—hence the name “cafeteria”). Employers like cafeteria plans because, in addition to having happier employees, they also save on taxes.
Important features of the plan
There may also be state income tax savings. Salary reductions lower earned income, which can impact the earned income credit for eligible taxpayers (though this is not the case in our example). In many cases, that can result in even greater tax savings.
The amount other employees will save depends on which family members are covered, the premiums for the coverage, the total family income, and the tax deductions and exemptions claimed.
It is important to know before signing the election forms that employees will not be able to change their benefit elections (i.e., the choices about which benefits to pay for through the cafeteria plan) or salary reduction amounts except at open enrollment and on the occurrence of certain events such as marriage or divorce. This rule is called the “irrevocable election requirement.”
Cafeteria Plans are regulated by IRS Section 125.
How does this work in real life?
Take the example of Widgets, Inc. John DoGood is the president of Widgets, Inc., a company with 70 employees. One of his new hires, Jane, just came from MegaCo., which has thousands of employees and sponsors a cafeteria plan. She has been asking Mr. DoGood to set up a cafeteria plan for Widgets, Inc., but to be honest, Mr. DoGood does not really know what a cafeteria plan is.
“What good would this be? Sure, it might make sense for a big company like MegaCo., but Widgets, Inc. is just not in that league. Besides, Widgets, Inc. already provides a solid health insurance plan!”
Widgets, Inc. currently pays for 80% of employee-only premiums, and employees pay the remaining 20%. Employees with families pay 100% of the cost of coverage for their spouses and children. The employees’ share of the cost is deducted from their pay on an after-tax basis.
Could a cafeteria plan work for Widgets, Inc.?
Yes! Its employees could easily benefit from a premium-only plan (POP). A POP is the simplest type of cafeteria plan. It is designed for one purpose: to help employees save money by letting them pay for their share of insurance premiums with pre-tax dollars.
Premium-Only Plan (POP) Description
Mr. DoGood understands now: a POP really makes sense for a business like his. Employees are already making after-tax payroll deductions to pay for their share of insurance costs. Just setting up the POP and telling payroll to take those same deductions on a pre-tax basis means that everyone gets to save money.
A cafeteria plan helps employers in other ways, as well. In addition to enabling the employer to save on its share of FICA (Social Security and Medicare) and FUTA (federal unemployment) taxes, a cafeteria plan can:
help recruit employees and keep them satisfied
increase flexibility to design employee benefits for diverse employee needs
in some states, save on state unemployment insurance and workers’ compensation taxes
cushion the blow of huge premium increases
increase employee awareness of the cost of each benefit
“I like it,” says Mr. DoGood, “but what’s the catch?”
Well, the IRS does not give out tax breaks without getting some assurances that they’re being used properly. Widgets, Inc. will have to meet some legal requirements, but this is easy so long as Mr. DoGood gets good legal advice in setting up and operating his plan.
“That’s what I was worried about,” says Mr. DoGood. “Attorneys! I’m not MegaCo., you know, I have a small budget and I can’t afford more administrative staff right now.”
No worries. The POP has minimal set-up costs. Just tell the payroll folks what to do and how to explain the plan to employees. Someone also needs to handle the distribution and collection of election forms. A third-party administrator, like Rocky Mountain Reserve, can help with these tasks and Widgets, Inc. will still save money!
How much will his employees really save on taxes?
Take Jane as an example. She is married and has one child. The company pays for 80% of Jane’s own health insurance but nothing for her family. She pays $6,400 in premiums ($700 for her share of the employee-only premium, plus $5,700 for family coverage) under Widgets, Inc.’s health insurance plan. In 2020, Jane earns $75,000 and her husband (a student) earns no income. They file a joint tax return.
Jane would save about $1,450 in taxes (line 11, col. 1 minus line 11, col. 2) by paying for her health insurance premiums under the POP. A shortcut way to determine Jane’s savings is to multiply 22.65% by her $6,400 of salary reductions (22.65% = her 15% marginal tax rate plus 7.65% for FICA).
Widgets, Inc. also saves on taxes. For example, it saves $490 in FICA employment taxes (i.e., 7.65% × $6,400 of salary reductions).
No wonder Jane wants a cafeteria plan—it results in significant tax savings. There are some other bonuses as well:
employees pay only for the benefits they really want (i.e., they can design their benefits “à la carte”)
often, more benefits are offered than might otherwise be available without a cafeteria plan