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Each year you will need to select your employee benefits during the timeframe your employer designates, called the “Open Enrollment Period”. There are many different options and sometimes it is difficult to determine which ones are best for you and your family. Cafeteria plans and flexible spending accounts (FSAs) are two ways that you can customize your benefit plan while receiving tax benefits and assistance with essential expenses. Be sure to understand how each option will affect your financial plan.
This article discusses the requirements to set up cafeteria plans and flexible spending accounts (FSAs) in detail. It also discusses the advantages and disadvantages of each plan, as well as the tax implications towards the employer and employees.
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What Are Cafeteria Plans?
A cafeteria plan is a plan where an employee may be able to choose the form of employee benefits from options provided by the employer. The plan has to include a cash option. It is a way to manage the employer’s benefit costs by pricing each benefit and providing a total dollar equivalency to each employee to shop for the best mix of benefits for themselves.
A cafeteria plan is appropriate when the employees’ needs vary due to a spread of young to older employees. With a cafeteria plan, the employee may choose the benefits package that is most suited to their individual needs. However, the employer needs to be able to afford the expense of such a plan.
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Advantages vs. Disadvantages of Cafeteria Plans
A cafeteria plan has the advantage of being able to appreciate the value of their benefits package. It can also help employer costs by reducing the cost of benefits that employees might not need. However, cafeteria plans are complex and can be expensive to design and implement.
Cafeteria plans need to abide by the nondiscrimination requirements. The plan must be made available to a group of employees in a manner that does not discriminate against highly compensated employees.
There are complex tax requirements that need to be followed. Highly compensated employees can lose the tax benefits of the plan if it is discriminatory. The plan has to comply with IRC Section 125, which provides an exception to the constructive receipt doctrine. If the terms of Section 125 are not met, the employees can be taxed on the value of the benefit of the plan, even if they choose a qualified nontaxable benefit.
Cafeteria plans also have a limitation on nontaxable benefits to key employees. The nontaxable benefits that can be provided to key employees cannot be greater than 25% of the total nontaxable benefits provided to all employees under the same plan.
Under a cafeteria plan, only certain qualified benefits can be made available. An employer can offer an employee the choice between cash or a nontaxable benefit. If the employee chooses the benefit, it will remain nontaxable. But, if they choose the cash, it will be included as income.
Nontaxable benefits include accident and health benefits, dependent care services, group term life insurance, and health savings accounts. A cafeteria plan may not include scholarships, educational assistance, employee discounts, and retirement benefits.
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SIMPLE cafeteria plans
A SIMPLE cafeteria plan is one that a small business may use if they had 100 or fewer employees during either of the preceding two years. Employers may start the plan until they exceed 200 employees during the preceding year. All employees are includable in the plan if they have at least 1,000 hours of service during the preceding plan year. However, nonemployees or partners are not eligible.
Employees that do not meet the following requirements can also be excluded:
- Not yet 21-years-old by the end of the plan year
- Less than one year of service as of any day during the plan year
- Covered under collective bargaining agreement
- Nonresident aliens
Additionally, there are two contribution requirements:
- A uniform percentage of the employee's compensation or the lesser of 6% of the employee's compensation
- 200% of the employee's salary reduction contribution
A SIMPLE cafeteria plan is advantageous because it is not subjected to the nondiscrimination requirements as long as they meet the minimum eligibility, participation, and contribution requirements. Due to this, there will also be a reduced administrative burden for small employers.
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Flexible Spending Account (FSA)
A flexible spending account (FSA) is a cafeteria plan where employees can get reimbursed for certain types of qualified expenses. The plan is usually funded by voluntary pre-tax salary reductions, but can also include employer contributions.
There are two types of FSAs: (1) Health FSA and (2) Dependent Care FSA.
Health FSAIn a Health FSA, employees can contribute up to $2,700 during 2019, not including an employer contributions. Amounts contributed by employees are not subject to federal income tax, Social Security tax or Medicare tax.
However, you’ll want to keep in mind that Health FSAs follow either a use-or-lose provision or a limited carryover option. So, you’ll need to spend the funds on eligible expenses before you no longer have access to the unspent funds.
Dependent Care FSA
In a dependent care FSA, a limit of $5,000 applies for those filing single or head of household as well as those couples who are married filing jointly during 2019. The limit for married individuals who file separately is $2,500 for 2019.
This type of account covers eligible expenses for childcare and adult care, but make sure to keep your receipts and supporting documentation in case the IRSA requests them.
An FSA is most appropriate for employers who wish to expand their employee benefit choices without having to pay extra out of pocket costs.
An FSA can be utilized in the following circumstances:
- An employee has a spouse with duplicate medical coverage
- When employees contribute to health insurance costs
- When employers have medical plans that have large deductibles
- When the employees are nonunion
- When there is a need for benefits that are difficult to provide in a group basis
An employee can also choose to participate in both a health FSA and a dependent care FSA for a total salary reduction of $7,700 as of 2019.
An FSA can provide tax benefits for employees that are usually not available from other plans. Due to administrative costs, an FSA is usually not practical for businesses with few employees. FSA benefits are also not allowed to be provided to self-employed individuals or partners.
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Advantages vs. Disadvantages of an FSA
An FSA can come with several advantages. An FSA can be funded entirely by an employee’s salary reduction and will require no extra expenses by the employer besides administrative costs. Contributions are also not subjected to payroll taxes.
Salary reductions that are elected by employees to fund the plan are not subjected to federal income taxes or payroll taxes. Using an FSA to pay for dependent care expenses can provide more tax savings using the child and dependent care credit depending on the taxpayer’s marginal income tax rate and adjusted gross income. However, there are also some disadvantages that come with an FSA.
An FSA has to meet all the complex nondiscrimination requirements for cafeteria plans. It also requires an employee to evaluate their personal and family benefit situations and file an election form every year to estimate their benefit needs.
The plan can result in an adverse selection that could raise the benefit cost. An FSA also has large administrative costs, larger than a fixed benefit plan. The IRS has proposed regulations that require an employer to be at risk for the total annual amount an employee can elect to allocate to health benefits under their FSA.
Additionally, amounts in an FSA can be lost if the employee fails to use all the contributed amount within a certain period. Long term care services are not able to be reimbursed tax-free under an FSA. Over the counter drugs and medication are also not eligible for reimbursement.
In an FSA, an employee’s salary reduction that is applied to nontaxable benefits will not be subjected to income tax. The employer will also receive a tax deduction for any amount that is paid. The employer's payroll that is subjected to taxes will be reduced by the amount of the employee salary reduction under an FSA.
Contributions towards the FSA are not subjected to FICA or FUTA, state unemployment taxes are not paid, and workers compensation is also not paid.
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If you need assistance determining which benefit options are right for you, reach out to your Human Resources Department. They will help you understand the conditions of each one offered. Additionally, you can reach out to your accountant and financial planner to see how each benefit will affect your goals.