What Is IRC 125 and How Do Cafeteria Plans Work?
Explore the essentials of IRC 125 and understand how cafeteria plans function, including eligibility, benefits, and tax implications.
IRC 125, a component of the U.S. tax code, addresses cafeteria plans—employee benefit programs offering flexibility in choosing from a variety of pre-tax benefits. These plans are popular among employers seeking to provide customizable benefits packages that cater to diverse employee needs while offering tax advantages for both parties.
This article examines the statutory framework governing IRC 125, explores non-discrimination criteria, salary reduction arrangements, tax withholding impacts, and identifies prohibited offerings within these plans.
Statutory Framework
IRC 125 establishes the legal foundation for cafeteria plans, ensuring compliance with federal tax regulations. It allows employees to select benefits like health insurance and retirement contributions while offering a choice between cash and qualified benefits. The plans must be in writing, clearly outlining benefits, eligibility criteria, and election procedures to ensure transparency and accountability.
The framework includes non-discrimination rules to prevent preferential treatment of highly compensated employees, officers, or shareholders. Non-compliance can result in the loss of tax advantages, making adherence essential for employers.
Non-Discrimination Criteria
Non-discrimination criteria ensure cafeteria plans treat all employees fairly, covering eligibility, benefits, and key employees.
Eligibility
Eligibility requirements mandate that a sufficient proportion of non-highly compensated employees have access to the plan. The eligibility test, such as the ratio percentage test, ensures parity. For instance, if 80% of highly compensated employees are eligible, at least 70% of non-highly compensated employees must also qualify. Failure to meet these requirements risks the plan’s tax-favored status.
Benefits
The benefits test ensures that offerings do not favor highly compensated employees. On average, benefits for non-highly compensated employees must be at least 55% of those provided to highly compensated employees. Failing this test can result in benefits being reclassified as taxable income.
Key Employees
Key employees, as defined under IRC 416, include officers earning more than $215,000 (as of 2023), individuals owning more than 5% of the business, or those owning more than 1% with compensation exceeding $150,000. The top-heavy test ensures benefits for key employees do not exceed 25% of total benefits. If a plan fails this test, it could lose its tax-advantaged status, resulting in additional tax liabilities.
Salary Reduction Arrangements
Salary reduction arrangements allow employees to allocate a portion of their salary toward specific benefits on a pre-tax basis, lowering taxable income. These contributions can fund benefits such as health insurance premiums and flexible spending accounts (FSAs). The pre-tax nature of these contributions reduces federal income taxes, Social Security, and Medicare taxes.
Employees must make binding benefit allocation decisions before the plan year begins, typically during an annual open enrollment period. Changes are permitted only under qualifying events. Employers must document salary reduction agreements, specifying terms, contribution limits, and eligible expenses. For example, the 2024 maximum healthcare FSA contribution is $3,150, with a carryover option of up to $610 for the following year.
Tax Withholding Impact
Cafeteria plans reduce taxable income, impacting tax withholding. When employees allocate pre-tax dollars to benefits, their gross income decreases, lowering amounts subject to federal income tax withholding. Employers also save on Social Security and Medicare taxes due to reduced taxable payroll.
For instance, an employee contributing $2,500 to a healthcare FSA reduces taxable income by that amount. At a 22% marginal tax rate, this results in $550 in federal tax savings. Employers benefit from FICA tax savings, typically 7.65% of the reduced salary.
Prohibited Offerings
IRC 125 prohibits certain benefits to maintain compliance with federal tax regulations. Deferred compensation is excluded, except for 401(k) contributions, as it undermines the immediate tax advantages intended by the code.
Certain fringe benefits, including transportation benefits, educational assistance, and adoption assistance, are also prohibited under cafeteria plans. Offering cash payments or non-tax-free benefits, such as a cash-out option for unused benefits, could trigger tax consequences, jeopardizing the plan’s tax-favored status. Employers must carefully design plans to avoid including prohibited items.