What Is a Salary Reduction Cafeteria Plan and How Does It Work?
Explore how salary reduction cafeteria plans offer flexible benefits, tax advantages, and compliance essentials for both employers and employees.
A salary reduction cafeteria plan offers employees a way to allocate pre-tax earnings towards specific benefits, leading to significant tax savings. This arrangement is attractive for both employers and employees seeking cost-effective benefit solutions.
Key Features
A salary reduction cafeteria plan, also called a Section 125 plan, allows employees to select from various pre-tax benefit options, reducing their taxable income. This flexibility enables employees to tailor benefits to their needs. Governed by Section 125 of the Internal Revenue Code, these plans must comply with nondiscrimination rules to ensure fair distribution among employees. Employers conduct annual tests, such as the key employee concentration test and the 25% concentration test, to maintain compliance.
Many plans include a “use-it-or-lose-it” provision, especially for Flexible Spending Accounts (FSAs), where unused funds may be forfeited at the end of the plan year. Some plans offer a grace period or carryover option to mitigate this. Employees should plan carefully to maximize benefits and minimize potential losses.
Eligible Options
A salary reduction cafeteria plan provides options like healthcare coverage, dependent care, and other qualifying expenses. Employees should understand these offerings to make informed decisions.
Healthcare Coverage
Employees can use pre-tax dollars for medical expenses, including health insurance premiums, Health Savings Accounts (HSAs), and FSAs. For example, an employee earning $50,000 annually who allocates $2,000 to an FSA reduces their taxable income to $48,000. HSA contributions are subject to IRS limits, which for 2023 are $3,850 for individuals and $7,750 for families. Employees should assess their healthcare needs to optimize contributions and avoid forfeiting unused funds.
Dependent Care
Dependent Care Flexible Spending Accounts (DCFSA) allow employees to allocate pre-tax earnings for expenses like daycare or elder care. The IRS limits DCFSA contributions to $5,000 for single filers and married couples filing jointly, or $2,500 for married individuals filing separately. For example, an employee contributing the maximum $5,000 could save over $1,000 in taxes, depending on their tax bracket. Evaluating dependent care needs is essential to maximize this benefit.
Other Qualifying Expenses
Cafeteria plans may cover adoption assistance, group-term life insurance, and transportation benefits. Adoption assistance benefits have an exclusion limit of $15,950 per child for 2023. Group-term life insurance premiums for coverage up to $50,000 are excluded from taxable income. Transportation benefits have monthly IRS limits of $300 each for commuter transit and parking. Employees should consider their circumstances to determine which benefits suit their needs.
Tax Considerations
Salary reduction cafeteria plans reduce taxable income, lowering federal income taxes. As of 2024, certain benefits are excluded from gross income under IRS rules. Employers must ensure compliance with nondiscrimination requirements to maintain the plan’s tax-favored status. Noncompliance can lead to penalties and additional tax liabilities.
State and local taxes may also be affected by cafeteria plans, as some states have specific rules that differ from federal tax treatment. Employees and employers should consult tax professionals to understand their jurisdiction’s requirements. Contributions to cafeteria plans generally do not reduce Social Security and Medicare taxes.
Enrollment and Contribution Methods
During an organization’s annual open enrollment period, employees select their benefits for the upcoming year. Employers provide resources like information sessions and online tools to guide employees in making informed choices. Contribution amounts are deducted from salaries throughout the year, with limits varying by benefit type. For example, HSA contributions in 2023 are capped at $3,850 for individuals and $7,750 for families. Careful planning is necessary to avoid underfunding or overcommitting.
Plan Compliance
Compliance with regulatory requirements is critical to maintaining a salary reduction cafeteria plan’s tax advantages. Employers must adhere to Section 125 of the Internal Revenue Code, conducting nondiscrimination tests like the eligibility test, benefits test, and concentration test to ensure fairness. For instance, the 25% concentration test ensures key employees do not receive more than 25% of pre-tax benefits.
Employers must also meet reporting and disclosure obligations. This includes providing a Summary Plan Description (SPD) to employees and filing Form 5500 with the Department of Labor if the plan covers more than 100 participants. Accurate documentation of employee elections, contributions, and plan amendments is necessary to demonstrate compliance during audits. Proper adherence safeguards the plan’s tax-favored status and helps avoid penalties.