It’s common for employers to require employees to pay a share of premiums for many employee benefits. To take a bite of this cost-sharing requirement, many employers permit employees to pay for their premium share of contributions on a pretax basis through cafeteria plans, which provide a special exception to general federal income tax rules applicable to an employee’s income.
“Generally, this choice takes the form of allowing employees to purchase benefits, such as health insurance, with pretax dollars. This allows employees to have more take-home pay,” says Frances Horn, employee benefits compliance officer at JRG Advisors.
But when providing this, there are requirements that must be met.
Smart Business spoke with Horn about the rules that govern these cafeteria plans.
How do cafeteria plans work?
Section 125 of the Internal Revenue Code (IRC) governs cafeteria plans. Thus, regardless of whether the cafeteria plan is from a private, government, church or nonprofit employer, it remains subject to the cafeteria plan rules.
Although all cafeteria plans must satisfy key Section 125 provisions, not all plans are the same. The simplest form is a premium-only-plan (POP), which permits employees to pay premiums with pretax dollars. An employer can also combine the premium payment feature with account-based plans to create a more robust plan. Account-based plans, or spending accounts, permit employees to set aside part of their salary on a pretax basis for unreimbursed expenses.
Cafeteria plans are often referenced by other names — most notably, POP, section 125, pretax plan and flexible benefits plan. Regardless of what employers call it, if they provide pretax benefits to employees, the plan must adhere to the IRC 125 rules.
What do employers need to understand about the IRC 125 rules?
The IRC rules governing 125 plans are numerous, but the most important one is that the cafeteria plan must be established pursuant to a written plan instrument, known as a plan document. Any changes made to the plan also must be set out in writing. This establishes the terms as to how the plan must be governed and any failure to operate in accordance with the terms or the IRC requirements will disqualify the plan.
The rules specifically define what must be included in the plan document:
- Specific description of the available benefits and when they are provided.
- Participation rules.
- Employee election procedures — when they can be made, effective date and that elections are irrevocable except for IRS permissible midyear election changes.
- The manner in which employer contributions may be made.
- Maximum amount of employer contributions available through the plan.
- The plan year.
- Provisions for complying with spending account arrangements, if offered.
- If the plan provides for any grace periods or carry-overs when permitted.
Without a plan document, the IRS takes the position that the employer has under-withheld the taxes for participating employees. Such under-withholding could lead to payroll tax underpayments and IRS penalties for an employer.
How does this differ from Employee Retirement Income Security Act (ERISA) plan documents?
This requirement shouldn’t be confused with the requirement that a benefit subject to ERISA is required to have a written plan document. Whether the cafeteria plan must meet ERISA’s plan document requirement depends on whether the plan contains an ERISA benefit. For example, this would occur if the cafeteria plan permits pretax salary reductions for a health flexible spending account, because it is a self-insured group health plan and subject to ERISA.
What else would you like to share?
If there is no cafeteria plan document, if the document doesn’t satisfy the plan document requirements or if the plan fails to operate in accordance with the terms of the plan or Section 125 rules, the plan isn’t a cafeteria plan and an employee’s election between taxable and non-taxable benefits results in gross income to the employee.
Make sure you discuss the proper establishment of cafeteria plans with your employee benefit advisors.
Insights Employee Benefits is brought to you by JRG Advisors