Employers understand that offering a broad range of employee benefits can help attract, motivate, and retain key employees. One benefit that an increasing number of employers are adding to their employee benefits package is a cafeteria plan (also known as a flexible benefit plan).
A cafeteria plan is a written plan under which participants may choose their own menu of benefits consisting of “cash” and “qualified” benefits. Cash here means:
- Cash from current compensation (including salary reduction);
- Payment for annual leave;
- Sick leave, or any other paid time off;
- Severance pay, property; and
- Certain after-tax employee contributions.
A qualified benefit must generally be excludable from an employee’s gross income and includes:
- Group-term life insurance on an employee’s life (up to $50,000);
- Employer-provided accident and health plans (including flexible spending arrangements);
- Dependent care assistance programs;
- Adoption assistance programs;
- Accidental death and dismemberment policies;
- Contributions to a 401(k) plan;
- Contributions to health savings accounts (HSAs);
- Contributions to certain plans maintained by educational organizations; and
- Long-term and short-term disability coverage
A cafeteria plan can save payroll taxes for both the employer and the employee. Pay that is contributed to the cafeteria plan is not subject to Social Security/medical taxes (FICA) or to federal unemployment taxes (FUTA). These tax savings essentially lower the cost of the benefit and lower year-end W-2 wages.
Can I Establish a Cafeteria Plan?
Any employer with employees who pay income taxes is eligible to sponsor a cafeteria plan. A C corporation, an S corporation, a Limited Liability Company (LLC), a partnership, a sole proprietorship, and governmental entities can establish a cafeteria plan. However, non-employees are not eligible to participate, including partners in a partnership, members of an LLC, and individuals who own more than 2% of an S corporation.
Types of Cafeteria Plans
There are three primary types of cafeteria plans:
Flexible Spending Accounts — A flexible spending account allows employees to set money aside using pretax payroll deductions to pay for out-of-pocket expenses that are not covered by insurance, such as annual deductibles, office co-payments, prescriptions, and orthodontia. Pretax payroll deductions reduces an employee’s taxable income, which, in turn, increases the percentage of pay he or she will take home.
Full-Flex Plan — With a full flex plan, the employer provides a fixed dollar amount for each eligible employee. The employee uses that money to select what he or she wants from a menu of benefits. If the benefits end up costing more than the sum allotted by the employer, the employee can make up the difference by using pretax salary deductions.
Premium Only Plan (POP) — This type of plan allows employees to have pretax deductions taken from their salary to cover employer-sponsored health insurance plans. POPs are frequently used in conjunction with Flexible Spending Accounts and Dependent Care Assistance Plans. Plans that are eligible are restricted to the employer’s group plans – medical, dental, vision, and certain voluntary products.
Employer Requirements
Once an employer decides to sponsor a cafeteria plan, the employer is required by law to adhere to specific regulations. The employer must:
- Create a written plan document that outlines the administration of the plan
- Ensure that employee election changes are limited to those permitted by law
- Comply with the nondiscrimination requirements that are designed to prevent the plan from favoring highly compensated or key employees
Cafeteria plans can be complex. Employers should work closely with a financial professional with an expertise in employee benefits and in the tax law to determine if sponsoring such a plan makes sense for their business.