Also known as a “cafeteria plan” and “flexible spending plan”, a 125 plan is a cost-effective way for a small business owner to offer more employee benefits on a tax-advantaged basis. It also serves as an excellent tax saving technique for employees with access to a cafeteria plan at work.
The 125 is a qualified plan that must offer two or more benefits. Common examples of benefits included in a 125 plan are the employee’s share of group health insurance premiums, term life insurance, vision/dental care, accident/disability insurance, and dependent care expenses.
Employee salary reductions run through the 125 plan and reduce the employee’s taxable income; the employer does not pay payroll tax on employee contributions. This is called a Premium Only Plan and it is a simple way for employees to select the benefits they want while increasing their take-home pay through lower taxes.
The Flexible Spending Account is a more complicated 125 plan. Each plan year the employee earmarks a predetermined amount of their wage income to be withheld each pay period to fund their individual FSA account. Funds are withdrawn by the employee to pay for eligible medical, transportation and dependent care expenses. However, the plan’s use-it-or-lose rules require that all FSA funds be expended each plan year or they are forfeited to the employer.
Per tax law, a 125 plan cannot discriminate in favor of the business owner and a Sub S owner/spouse, partners and self-employed owners cannot participate in the plan.
As benefit plan specialists, we help employees take full advantage of the tax benefits of the cafeteria plan and assist employers to improve their employee compensation program using either form of the 125 plan.
