§125 Benefit Plans

§125 benefit plans and tax implications

Goals and takeaways

• Understand the structure and purpose of §125 (Cafeteria) Plans

• Identify which benefits qualify under §125, including FSAs and dependent care

• Learn the tax treatment and reporting requirements for each component

What is a §125 (Cafeteria) Plan?

• The plan must be in writing

• All participants must be employees

• Employees must have the choice between at least two benefits (cash or qualified benefits)

Qualified benefits under §125

• Medical, dental, and vision insurance

• Group-term life insurance (up to limits; excess may be imputed)

• Dependent care assistance (up to annual limits)

• Short- or long-term disability coverage

• Flexible Spending Arrangements (FSAs)

• Elective contributions to 401(k) plans (FICA taxable)

• Cash in lieu of benefits (taxable)

Most employers offer either a full cafeteria plan or a POP (Premium Only Plan), which allows pre-tax deductions for insurance premiums without offering a full menu of choices.

Important restrictions

• No deferrals (except 401(k)) are allowed

• Benefits must be used during the plan year; unused amounts may be forfeited

• Reimbursements cannot be issued in advance

• Employees must authorize all deductions in writing

Tax implications

• Reduce federal income tax, FICA, and FUTA taxable wages

• May or may not reduce state or local taxable wages depending on jurisdiction

• Must be deducted from employee compensation (wages, bonuses, PTO, etc.) to qualify as pre-tax

Deductions made outside compensation (e.g., while on unpaid leave) must be treated as after-tax.

Example

• Aaron elects:
• $125 for STD/LTD
• $200 for dependent care
• $100 for health FSA
• Declines medical coverage and receives $175 in cash in lieu (taxable)

Flexible Spending Arrangements (FSAs)

1. Health care FSA

2. Dependent care FSA

3. Adoption assistance FSA (not covered in detail)

FSA rules

• Cannot reimburse insurance premiums

• Cannot mix expense types across FSA types

• Each FSA must operate under a defined 12-month plan year

• Expenses must be substantiated (paper or electronic)

Health care FSA

Key requirements

• Full plan year election: Employees must elect the total amount upfront

• 2022 contribution limit: $2,850 (employers may set a lower cap)

• Use-it-or-lose-it: Unused funds are forfeited unless the plan includes one of the following:

Grace period

• Allows use of funds for 2.5 months after plan year ends

• Must be included in the plan document

• Example: Elizabeth has $200 left and uses it for expenses incurred by March 15 of the following year

Carryover

• Allows up to $570 (2022) to roll over

• Cannot be used in the same plan year as a grace period

• Employers may require current-year funds to be used first

Uniform coverage

• The full elected amount must be made available immediately

• If an employee resigns before full repayment, the employer absorbs the loss

Example: Roger elects $2,850, uses it in January, and leaves mid-year. Only a portion is deducted before resignation, but the employer cannot accelerate repayment.

Dependent care FSA

Key differences

• Reimbursements only allowed after funds are contributed

• Annual limit: $5,000 (does not increase annually)

• Uniform coverage does not apply

Experience gains and forfeitures

1. Retain unused funds

2. Apply forfeitures to:
• Reduce contributions for the following year
• Refund employees uniformly
• Offset administrative costs

Reporting requirements

Forms W-2 and 941

• Pre-tax §125 deductions reduce taxable wages on both forms

• Dependent care FSA:
• Up to $5,000 reported in Box 10
• Excess amounts must also be included in Boxes 1, 3, and 5

• Group-term life (over limits): Box 12, Code C

• 401(k) deferrals: Box 12, Code D

Ensure cash-in-lieu amounts are added to Box 1 wages.