Is Your Health and Welfare Pay Taxable?
The tax treatment of Health and Welfare pay depends on its distribution, affecting whether it is considered taxable income or a non-taxable benefit.
Health and Welfare pay, often abbreviated as H&W, is a specific type of compensation provided to employees working on certain federal service contracts. These requirements are governed by the McNamara-O’Hara Service Contract Act (SCA), which applies to prime contracts with the U.S. government that exceed $2,500. The SCA mandates that contractors pay their service employees not only a minimum wage but also a separate fringe benefit amount, which is the H&W pay. This rate is determined by the Department of Labor and is specified in the contract’s wage determination document.
The purpose of H&W pay is to ensure that employees on these federal contracts receive compensation beyond their standard hourly wages to cover costs associated with benefits like health insurance or retirement plans. The H&W amount is calculated as a flat hourly rate for each hour an employee works on a covered contract, up to a maximum of 40 hours per week. This system ensures a consistent and predictable fringe benefit contribution for eligible employees.
Tax Rules for Cash-in-Lieu Payments
When an employer chooses to satisfy the Health and Welfare obligation by paying the amount directly to an employee in cash, these payments are treated as taxable wages. This method, often called “cash-in-lieu” of benefits, means the cash payment is added to the employee’s regular earnings and becomes part of their gross income.
These cash-in-lieu payments are subject to all standard payroll taxes. This includes federal income tax withholding, state and local income taxes, and FICA taxes, which fund Social Security and Medicare. For example, if an employee’s H&W rate is $5.36 per hour and they work 40 hours in a week, they would receive an additional $214.40 in their paycheck. This entire amount would be subject to the same tax withholdings as their regular wages.
Using Funds for Bona Fide Fringe Benefits
Employers can deliver Health and Welfare (H&W) pay on a non-taxable basis by using the funds to purchase “bona fide” fringe benefits for their employees. When H&W contributions are directed into a qualifying benefit plan, their value is excluded from an employee’s gross income for tax purposes. The Department of Labor provides specific criteria for what constitutes a bona fide benefit plan under the Service Contract Act (SCA).
A plan is considered bona fide if it is established through a formal trust or a third-party insurance arrangement, ensuring the funds are irrevocably paid and cannot revert to the contractor. The plan must also have a definite formula for determining the contributions and the benefits provided to employees.
A wide array of benefits can qualify under this framework, including:
- Medical, hospital, dental, and vision care plans
- Life insurance
- Short-term and long-term disability insurance
- Sickness and accident insurance
- Contributions to a retirement plan, such as a 401(k)
How Health and Welfare Pay Appears on Form W-2
The way Health and Welfare (H&W) pay is reported on an employee’s Form W-2 depends on how the funds were distributed.
If an employer pays the H&W amount as cash-in-lieu of benefits, the total cash payment is included in the employee’s taxable wages. This amount will be part of the figures reported in Box 1 (Wages, tips, other compensation), Box 3 (Social Security wages), and Box 5 (Medicare wages and tips).
Conversely, when H&W funds are used to pay for bona fide fringe benefits like health insurance premiums, these amounts are excluded from the taxable wages in Boxes 1, 3, and 5. However, some information may still appear on the W-2 for informational purposes. For instance, the total cost of employer-sponsored health coverage is often reported in Box 12 with the code “DD”, which does not increase taxable income but provides transparency on the value of the benefits. Other benefit contributions might be noted in Box 14, labeled “Other,” at the employer’s discretion.
Employer Obligations for Administration
Employers with contracts subject to the Service Contract Act (SCA) have specific administrative responsibilities for managing H&W pay. A primary duty is to accurately track the H&W fringe benefits owed to each service employee based on the hourly rate specified in the contract’s wage determination.
Maintaining clear records is an important requirement. Employers must keep documentation that separates H&W payments from regular wages and substantiates how the obligation was met, whether through contributions to benefit plans or as direct cash payments. This documentation is necessary to demonstrate compliance during any potential audits by the Department of Labor.
Employers must also address situations where the cost of benefits is less than the required H&W rate. If there are leftover funds after paying for insurance premiums or other benefits, the remaining balance must be paid to the employee as taxable cash. This ensures the employee receives the full value of the mandated fringe benefit, with the residual amount being treated as additional wages.