Taxation of IRS Section 125 and Health Insurance

by Natalie Grace

    A Section 125, or cafeteria, plan meets the criteria of Section 125 of the Internal Revenue Code. If your employer provides Section 125 plan benefits, you receive a tax break on your contributions. Your deductions are pretax, which means they come out of your wages before the tax is withheld.

    Inclusions

    Health insurance is a core aspect of a Section 125 plan. Your employer may offer a full range of health benefits, including medical, dental, vision, accidental death, dismemberment and disability insurance. Or it may stick to the basics of medical and dental. You must go through your employer’s Section 125 plan to obtain health insurance on a pretax basis. The plan may also include life insurance, adoption assistance, dependent care assistance, health savings accounts and group legal services.

    Federal Taxation

    Most Section 125 deductions, including for health insurance, are excluded from federal income tax, Social Security tax and Medicare tax. However, this isn’t always the case. For example, Social Security and Medicare taxes must come out of premiums for group-term life insurance of more than $50,000 in coverage and for adoption assistance, but not federal income tax. Flexible spending accounts, such as health savings accounts and dependent care assistance, of up to $5,000 are exempt from all federal taxes. Amounts of more than $5,000 are taxable and are included in your taxable wages on your annual W-2. For clarification on federal taxation of Section 125 plans, consult the Internal Revenue Service.

    State Taxation

    State tax laws on Section 125 plans vary. The state may follow federal taxation treatment of Section 125 deductions or it may have exceptions. For example, in Pennsylvania, only contributions to a Section 125 plan for sickness, hospitalization, supplemental unemployment benefits, strike benefits and disability or death are excluded from Pennsylvania income tax . The same concept goes for local income tax, if you’re required to pay it. Consult the state revenue agency or local tax assessor for clarification on whether Section 125 deductions are taxable.

    Taxable Wages

    Federal, state and local withholding are based on taxable wages. To arrive at your taxable wages, subtract your Section 125 deductions from your gross wages. The rest is your taxable wages, upon which your withholding is based. If you did not have the Section 125 benefit, your entire gross pay would be taxable. Deductions that do not qualify as pretax are done on an after-tax basis.

    Considerations

    Along with IRS requirements, the state may have laws for cafeteria plans. For example, the state may require that an employer that chooses to offer health insurance do so under a cafeteria plan.

    About the Author

    Natalie Grace has been writing professionally since 2009. Her academic writings have been featured in several prominent national publications, which are available to schools and libraries. Grace has more than 10 years of experience in payroll-and-benefits administration, human resources and accounting. She writes regularly on these and other business-related topics for websites and private clients.

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