Flexible Spending Account (FSA)/Section 125

Flexible Spending Account

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Flexible Spending Account

Section 125 plans are also commonly referred to as cafeteria plans. While there are different types of Section 125 plans, each provides the opportunity to save money by reducing both the employer’s and employees’ tax liability.

 

What is a Section 125 plan?

A Section 125 plan may be established pursuant to rules found in the Internal Revenue Code Section 125. This IRC provision provides an exception to what is generally called the “constructive receipt doctrine.” Under the constructive receipt doctrine, offering an employee a choice between cash and an employee benefit requires that the amount that could have been received be included in the employee’s gross income.

A Section 125 plan allows employers to provide their employees with a choice between cash and certain qualified benefits without adverse tax consequences. Without a Section 125 plan, employee contributions can only be made with after tax dollars.

 

What are the different forms of Section 125 plans?

The three basic forms of Section 125 plans are:

  • Premium Only Plan
  • Flexible Spending Account
  • Full Cafeteria Plan

 

What is a Premium Only Plan?

The Premium Only Plan is the most basic type of Section 125 plan and the most popular. A Premium Only Plan allows employees to pay their portion of insurance premiums with pre-tax dollars, which in turn reduces both the employer’s and employees’ tax liability. Benefits that are typically offered within a Premium Only Plan include: health, dental, vision, accidental death and dismemberment and group term life insurance.

 

Example: Employer Tax Savings

Thirty employees elect health insurance coverage. Under a Premium Only Plan, an employee’s monthly premium contribution of $150 per month is paid with pre-tax dollars.

Employer Tax Savings With Premium Only Plan
Insurance Premiums
($150 X 30 employees)
$4,500
x     12
Annual Salary Reduction
$54,000
Employer Tax Rate*
9%
Employer Tax Savings
$4,860
*Includes FICA, FUTA, and estimated SUTA.

 FSA2

What is a Flexible Spending Account (FSA)?

A flexible spending account is an account in an employee’s name that can reimburse the employee for qualified health care or dependent care expenses. It allows an employee to fund qualified expenses with pretax dollars deducted from the employee’s paychecks. The employee can receive cash reimbursement up to the total value of the account for covered expenses incurred during the benefit plan year and any applicable grace period.

 

“Use it or lose it”

As required by the Internal Revenue Service (IRS), an FSA has a “use it or lose it” provision stating that any unused funds at the end of the plan year (plus any applicable grace period) will be forfeited. When electing an FSA during open enrollment, the employee must specify how much he or she would like to contribute to the FSA for the year. The goal is choosing an amount that will cover medical or dependent care expenses, but that is not so high that the money will be forfeited and wasted.

 

Example:  Employee’s Spendable Income Increases

Without Section 125 Plan
With Section 125 Plan
Annual Salary
$24,000
Annual Salary
$24,000
Federal Income Tax (15%)
–    3,600
Health Insurance Premiums
–    1,500
State Income Tax (3%)
–       720
Out of Pocket Medical Expenses
–       300
Social Security Tax (5.65%)
–    1,356
Child Care Expenses
–    2,800
Net Income
$ 18,324
Net Income
$19,400
Health Insurance Premiums
–    1,500
Federal Income Tax (15%)
–    2,910
Out of Pocket Medical Expenses
–       300
State Income Tax (3%)
–       582
Child Care Expenses
–    2,800
Social Security Tax (5.65%)
–    1,096
Remaining Spendable Income
$ 13,724
Remaining Spendable Income
$14,812
The example above demonstrates an annual increase in spendable income if both a Premium Only Plan and Flexible Spending Account are utilized. While use of either a Premium Only Plan or Flexible Spending Account alone would produce a savings, the increase in spendable income would be less. The example reflects the temporary reduction in the employee portion of the Social Security tax for 2011 and 2012 from 7.65 percent to 5.65 percent.

 

What is a Full Cafeteria Plan?

Under a Full Cafeteria Plan, the employer makes a non-elective contribution for every eligible employee. The employees may spend the employer contribution to purchase any of the benefits offered within the Cafeteria Plan. In addition, the employee may contribute pre-tax dollars to purchase additional benefits beyond what he or she can purchase with the employer’s contribution.

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