Taxation of IRS Section 125 and Health Insurance

By: Jayne Thompson | Updated December 16, 2018

The cost of benefits is on everyone's mind right now. If your employer provides a section 125 cafeteria plan – so-called because the plan resembles a menu of benefits for you to pick and choose from as if you were in a cafeteria line – you receive a tax break on your contributions. Once you understand the plan, it can be a great way to convert taxable salary into pre-tax benefit contributions, thus increasing your take-home pay.

What Is an IRS Section 125 Cafeteria Plan?

Section 125 of the Internal Revenue Code refers to cafeteria plan benefits. The plan is called a cafeteria plan because it includes a menu of benefits for employees to choose from. Some of the qualified benefits include health insurance, vision benefits, dental benefits, health savings accounts, dependent care assistance and 401(k) retirement contributions. The plan must include at least one qualified benefit to receive Section 125 status.

It's important to understand that a cafeteria plan is not health insurance, but a way of setting aside tax-free dollars to pay for certain types of benefits coverage. That said, health coverage plays a big part in most Section 125 plans. When cafeteria plans are offered, you can pay for your health insurance premiums from pre-tax dollars and, typically, a bunch of expenses that are not covered by insurance. Many medical expenses are covered including co-pays, deductibles, prescription drugs, cancer insurance and chiropractors.

How Does a Section 125 Cafeteria Plan Work?

The basis of a Section 125 plan is that it's a premium-only plan (POP) and/or a flexible spending account (FSA). The POP aspect allows you, the employee, to pay into the employer-sponsored health plan directly from your paycheck before any taxes are deducted. This has the effect of reducing your taxable income so you get more cash in your pocket at the end of the month.

Offered in conjunction with a group health plan, an FSA lets you set aside a predetermined amount of money each year to allocate to the plan, for example, $1,200 per year or $100 per month. The elected amount is automatically deducted from your paycheck each pay period before taxes are applied. You can use the money in the FSA to pay for benefits such as daycare for children, life insurance or group legal services on a pre-tax basis. Alternatively, you could opt to take the benefit as cash or switch it to another benefit that's included in the cafeteria plan.

It's this flexibility that makes Section 125 plans different from a traditional employer-provided health insurance plan. With a regular plan, the employer covers some or all of the employee's health premiums. If you decide you don't need health insurance, you lose the benefit. The employer won't give you an equivalent amount to put toward other benefits or towards your own salary as cash.

What are the IRS Section 125 Tax Rules?

There is no tax liability on money contributed to cafeteria plans. The plan allows you, the employee, to take your salary which is taxable and convert it to a non-taxable benefit. This tax break has the potential to save you thousands of dollars each year in payroll deductions because you're not paying income taxes, Social Security or Medicare on those dollars.

For example, if your combined payroll taxes total 22 percent and you allocate $100 of your pre-tax pay to a section 125 cafeteria plan, you would be able to spend the entire $100 on qualified medical expenses and other benefits, rather than only $78 received after taxes are deducted. Depending on your tax rate, you could be saving anywhere from 10 to 37 percent on premiums, giving you more take-home pay.

Section 125 saves your employer money, too, as the company does not have to contribute the matching Social Security, Medicare and unemployment taxes on the dollars you put in the plan. This saves your employer around 8 percent of all the contributions, which more than pays for the plan administration in most cases.

Contribution and Coverage Limits for Certain Benefits

There are limits on the amount of benefits that are available pre-tax, even when offered within a cafeteria plan:

  • In 2018, you cannot contribute more than $2,650 annually to an FSA. This amount will be indexed annually for cost-of-living adjustments
  • Premiums for group term life insurance premiums on coverage that exceed $50,000 are included in your taxable wages
  • Dependent care assistance contributions are pre-tax only up to $5,000 for a single parent and $2,500 for a married person filing separately in 2019. Amounts over the threshold are included in your taxable income on your annual W-2
  • Certain contributions made through a Section 125 plan are exempt from federal income tax in the usual way but they are subject to Social Security and Medicare taxes. These benefits include 401(k) contributions and adoption assistance.

These exceptions change regularly so consult the plan administrator or see the IRS Publication 15-B, Employer's Tax Guide to Fringe Benefits for clarification.

The Use It or Lose It Rule and Carryovers

Both FSAs and DCFSAs – Dependent Care Flexible Spending Accounts – are common features of a Section 125 cafeteria plan. With a DCSFA, the parents of children under 13 can set aside tax-free dollars to be spent on childcare expenses such as daycare, pre- and after-school care, nannies and summer camps.

With these accounts, you're funding the benefit expenses upfront. Contributions are made out of your salary first, and are reimbursed after a claim is made. Under a special rule known as the "use it or lose it" rule, any funds remaining in your account must be used by the end of the plan year or you will forfeit them. You are also locked into your designated contributions for one full year and you cannot change this. So, if you fall on hard times and want to stop you Section 125 contributions, you have to wait until the full year is up.

These limitations may not be as bad as they sound. If your employer offers a carryover concession, you can carry up to $500 worth of unused medical FSA funds to the following year without any fees or penalties. There's also a grace period concession which gives employees an additional two-and-a-half months after the end of the plan year to incur an expense and submit a claim for reimbursement. Employers can offer either concession, but not both, or they can offer no concessions at all.

Are Cafeteria Plans Subject to State Taxation?

State laws on Section 125 plans vary by jurisdiction. Pennsylvania, for example, only permits tax-free contributions for hospitalization, sickness, strike benefits, supplemental unemployment benefits, disability or death; other contributions are liable to state income taxes. Other states follow federal taxation treatment of Section 125 deductions or have their own exceptions. Contact the state revenue department for an explanation of which of your cafeteria plan deductions are taxable.

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About the Author

Jayne Thompson earned an LLB in Law and Business Administration from the University of Birmingham and an LLM in International Law from the University of East London. She practiced in various “big law” firms before launching a career as a commercial writer. Her work has appeared on numerous financial blogs including Wealth Soup and Synchrony. Find her at www.whiterosecopywriting.com.

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