A Section 125 Cafeteria Plan allows employees to pay certain qualified expenses on a pre-tax basis, effectively reducing their taxable income.
If you own a small business and haven’t made changes to your fringe benefits package in a while, you need to read this. If your definition of fringe benefit is a free turkey at Thanksgiving, you really need to read this! Sure, not every business can afford bean bag chairs for all, on-demand peanut butter and jellies or free haircuts for life, but there are plenty of more practical options to consider. One of those is a Section 125 Cafeteria Plan. In a tight labor market where competition for talent is fierce, the options you offer your employees may be the difference maker.
As a small business owner, how awesome would it be to potentially decrease you and your employees’ taxable income with little to no additional cash outflows from the business?
It may be possible with a Section 125 Cafeteria Plan.
Here’s what you need to know.
What is a Section 125 Cafeteria Plan?
A Section 125 Cafeteria Plan allows employees to pay certain qualified expenses on a pre-tax basis, effectively reducing their taxable income. The most common cafeteria plans are set up for dependent care and medical expenses.
Tax Advantage for Employees
The portion of an employee’s wages that they contribute to a Section 125 Cafeteria Plan is not subject to payroll or income tax if a qualified benefit is selected. This exemption from tax translates to an average savings of 25 to 49 cents for every dollar contributed. At the low end, this means if an employee contributes $4,500 to a qualified cafeteria plan benefit, they could potentially see $1,125 in savings. Cha-Ching! It is important to note that there are limitations on the amount that can be contributed each year and to what qualifies as an eligible expense.
Tax Advantage for Business Owner’s
The business owner also saves money when the employee contributes. Since, qualified benefits under a Section 125 Cafeteria plan are pre-tax, the employer does not have to pay in their side of employment taxes on the contributions. Say, as a business owner, you have 10 employees that each contribute $4,000 to qualified cafeteria plan benefits. At the end of the year that equates to a roughly $1,000 tax savings for each employee and a savings of about $3,000 in payroll taxes for the company. The company could also see savings related to unemployment and worker’s compensation insurance. Now, there are some administrative costs associated with running the plan but overall you will have likely saved some money and increased your position as a competitive employer.
Please keep in mind that this example is based on a specific situation and may not have the same effect to every business owner. As is always the case, we recommend speaking with a tax advisor to discuss the possible tax implications before moving forward with a Cafeteria Plan.