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Cafeteria Plans: What's on Your Menu?
Since everyone's needs are slightly different, employees don't always receive the type of company-paid benefits that they want. But there may be a relatively easy way for a company to satisfy their individual requirements. How? A so-called “cafeteria plan” generally allows the employees of a company to choose from a wide variety of tax-free fringe benefits.
The result is a two-way winner. (1) The employees opt for those benefits that best fit their situation. (2) The employer may reduce its overall costs by providing only those fringe benefits that the employees choose. Both sides can come out ahead on the deal.
Idea in Action
Typically, an employer sets up a written cafeteria plan and notifies its employees. Those who participate must be given a choice between at least two options. In general, the benefits available are those that employees are permitted to receive tax-free. Employees can also be given the option to receive cash in lieu of some or all of the available benefits.
The employer generally will pay for certain benefits, such as basic medical and disability coverage. The employee then customizes the rest of the benefits package by choosing “extras” such as dental coverage and up to $50,000 of group term life insurance coverage.
Also, the cafeteria plan can be used to reduce deductibles and coinsurance amounts, increase maximum coverage above the basic amounts provided by an employer, add coverage riders for benefits that are not available under the basic plan or select benefits that may not otherwise be available.
Cash vs. Benefits
Employees can elect between receiving part of their salaries in cash or as contributions to the cafeteria plan. Any cash that is received is taxed like other salary payments. For example, these amounts are subject to income and employment taxes.
On the other hand, benefits are not considered to be wages for income tax, FICA (Federal Insurance Contributions Act) or FUTA (Federal Unemployment Tax Act) purposes. So each dollar contributed to the plan buys more benefits than the employee would be able to get on an after-tax basis.
Example: Ms. Jackson elects to forego $7,500 of her annual salary. Instead, she chooses to receive $5,000 of dependent care assistance, $1,000 of dental coverage for herself and her dependents and $1,500 of medical options not covered under her basic health plan. Jackson is in the 28% tax bracket.
If Jackson had to purchase these benefits herself, they would cost her $10,417 in pre-tax dollars. And FICA tax savings could amount to as much as $573.75 a year each for both Jackson and her employer.
Nondiscrimination Rules
Certain highly compensated employees and key employees are denied some or all cafeteria plan benefits if the plan is discriminatory in nature. Specifically, the tax breaks from a cafeteria plan do not apply to a benefit received by a highly compensated participant for any year in which the plan is found to be discriminatory.
Who is considered to be highly compensated? Besides those who actually are highly paid employees (the figures are indexed every year for inflation), this term includes most officers and more-than-5% shareholders of the corporation. Also, any employee who is the spouse or tax dependent of a highly compensated employee is considered to be highly compensated—even if his or her actual compensation is low.
Who must be eligible to participate? Certain employees can be excluded from eligibility without violating the antidiscrimination rules if the following conditions are met:
*The plan must benefit a group of employees found by the IRS not to be discriminatory.
*No employee in the group can be required to complete more than three years of employment in order to be eligible to participate at the start of the following year.
*The length-of-employment requirement must be the same for all.
Note that there are special rules for collectively bargained plans. See your adviser for more details.
Caution: The antidiscrimination rules for cafeteria plans are complex. Your company should work closely with a benefits adviser to make sure all the requirements are satisfied.
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