Cafeteria Plans

Also commonly called flexible spending plans and section 125 plans, the cafeteria plan is an effective way to reduce taxable income of employees. This column addresses questions about cafeteria plans and their various requirements.

What is a cafeteria plan?

A cafeteria plan is any plan which allows your employee to choose between taxable compensation and funding one or more benefits tax free. Your employee pays for benefits with pre tax earnings. Your employee decides how much to set aside for each benefit before the plan year begins.

As an employer, why would I want to set up a cafeteria plan?

The best reason is because you and your employees both save money. A cafeteria plan reduces your employee's W-2 income, therefore they will pay less in income taxes. You will save money because with the reduction in your employee's W-2 income, you will pay less in payroll taxes.

What requirements must I meet as an employer to set up a cafeteria plan?

You must have a written plan where your employees may choose among cash or certain permissible benefits. Your cafeteria plan cannot discriminate in favor of highly compensated employees as to eligibility to participate or contributions and benefits. Also, nontaxable benefits to key employees cannot exceed 25% of the total nontaxable benefits provided under the plan.

Your written plan document must contain: a description of the benefits; the eligibility rules of participation and the rules regarding participant elections; the method in which contributions are made; the maximum amount of contributions that can be made; and, the plan year in which the plan operates.

What nontaxable benefits are permissible in a cafeteria plan?

Your employees can pay for the following benefits on a pre tax basis: medical, dental, disability, eye and other accident and health plan coverage, medical expense reimbursements, group term life insurance, dependent care assistance, adoption assistance benefits, coverage under a 401(k) plan, and qualified transportation costs.

Who are highly compensated employees?

Highly compensated employees for cafeteria plan purposes include officers or shareholders owning more than 5% of voting power or value in an employers stock and spouses and dependents of these individuals.

Who are key employees?

Key employees include officers, the ten employees owning directly or indirectly the largest interests in the employer, 5% owners of the employer, or 1% owners of the employer whose annual compensation exceed $150,000.

What are the eligibility rules for participation?

The eligibility rules are designed to protect participants from discrimination in favor of highly compensated employees. The Internal Revenue Code provides that a classification of employees who are eligible for a cafeteria plan will not be discriminatory if three conditions are met:

First, the plan must be set up by the employer and found not to be discriminatory in favor of highly compensated employees. Second, no employee is required to complete more than three years of employment with the employer maintaining the plan as a condition of participating in the plan, and the employment requirement for each employee is the same. Third, once an eligible employee has completed the required years of employment, he must commence participation no later than the first day of the next plan year unless the employee has separated from service before the first day of that plan year.

I am self-employed. Am I eligible for participation in a cafeteria plan?

No, self-employed individuals are not eligible for participation in a cafeteria plan. Cafeteria plans are for employees only and the cafeteria plan rules exclude self-employed individuals from the definition of an employee. Additionally, partners in a partnership may not participate in a cafeteria plan maintained for the partnership's employees. And since a 2% shareholder of an S corporation is treated as a partner of a partnership for fringe benefit purposes, such shareholders are also excluded from participation in a cafeteria plan.

What are the rules regarding participant elections? Can I as an employee, change which benefits or amounts I want to contribute to the plan once the plan year is underway?

Prior to your participation starting date you review the benefits allowed in the plan and make your election. You elect the amounts you wish to have withheld from your pay for the various types of investments. Your election must generally be irrevocable. In general, the election will not be deemed to be made if, after you have elected and began to receive a benefit under the plan, the participant is permitted to revoke the election for that plan year. However, there are changes in status exceptions in which you can revoke or change your election. These exceptions are listed below.

• An event that changes your legal marital status
• An event that changes your number of dependents
• A change in your employment status or your spouse's or dependent's
• An event that causes an employee's dependent to satisfy or cease to satisfy the requirements for coverage due to attainment of age, student status or any similar circumstance
• A change in the place of residence of the employee, spouse or dependent
• For the adoption assistance benefits, the commencement or termination of an adoption proceeding

Additionally, final regulations regarding cafeteria plans have been issued allowing revocation due to certain other events. If insurance premiums increase or decrease during a plan year, the cafeteria plan can automatically increase or decrease the elective contribution of the participants. If there is an increase in deductible, co-pay or out-of-pocket cost sharing limit, due to a change in coverage under the plan, the participant may elect to receive coverage under another benefit package providing similar coverage. If the plan adds a new or improved benefit package or coverage option during a plan year, the participant may elect to revoke their election under the cafeteria plan and make an election for coverage under the new or improved benefit package option.

You cannot change your health care flexible contribution amount simply because you change coverage or you have higher than expected costs. You also cannot change your dependent care contribution for a cost increase to a relative.

What happens to my money if my actual benefits paid out are less than what I put into my cafeteria plan at year end?

You will lose the extra amount contributed, which is why you want to be careful when estimating the amount of pre-tax dollars you want to set aside in a cafeteria plan account. If you do not claim your full amount within 60 days after the close of the plan year, you will have to forfeit all rights to those funds. Starting in 2005, an employee can have up to two and a half months beyond the end of the plan year to use these funds, if the plan allows. Exercise caution not to over fund your cafeteria plan. Use only expenses you are sure you will have over the next plan year when deciding how much to put into the plan each year. Be sure to ask your employer what the true grace period is for your particular plan.

What will it cost me to set up a cafeteria plan for my employees?

The cost ranges from $750 to $5,000 for the first year and will be lower thereafter. We have access to a pre-written plan which can be set up at a relatively low cost.

©2006 by Dierking Lockie & Associates PC
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