How Does a 125 Plan Work?

The best part about the Section 125 plan is that most of your employees are already paying for these expenses out of their own pockets with after-tax dollars. Cafeteria plans offer them a remarkably easy way to save money they're already spending.

Here's how the Section 125 FSA component works:

1. Prior to the beginning of each plan year, an employee estimates how much they'll spend in out-of-pocket medical expenses and/or dependent care expenses during the course of their plan year. (The plan year would be defined in their summary plan description).

Note: It's important for employees not to overestimate their annual election amounts, as the FSA is a "use it or lose it" benefit and they'll forfeit any unused balance remaining in the account at the end of each plan year. (There's a grace period for which an employee can file claims for each plan year.) If there's a FSA surplus at the end of the plan year, the remaining balance shall be retained by the employer to offset administrative expenses or future employee benefit costs.

2. This amount is then deducted over the course of the plan year from their paychecks prior to being taxed and is deposited into their flexible spending account. On or after the first day of the plan year, an employee is restricted from changing or revoking the section 125 agreement with respect to the pre-tax premiums until the plan year has ended unless a "change in family status" occurs (as defined under the federal tax code) and the change is consistent with the "change in family status."

3. Your employees would pay their out-of-pocket expenses upfront and then submit a claim and documentation to the plan administrator. A reimbursement would then be made from their own Health FSA or DCAP account with pre-taxed dollars and sent to them in the form of a check.

So what are the Section 125 Cafeteria Plan benefits to you as the employer?

1. Every dollar run through the Section 125 plan reduces an employer's payroll. Therefore, you don't have to pay FICA or workers' comp premiums (depending on your State) on those dollars. In many cases, this savings can add up to as much as 20 percent of every dollar being passed through the plan.

2. Implementing a Section 125 Cafeteria Plan can "soften the blow" of premium increases to employees.

3. Employers are using 125 plans to move to "higher deductible" less expensive medical plans and putting the difference in the Spending accounts of the employees.

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And what are the Section 125 Cafeteria Plan benefits to your employees?

1. Participating in a cafeteria plan reduces an employee's taxable salary and increases the percentage of their take-home pay, thus increasing their spendable income.

2. They receive a greater deduction on dependent care expenses than what's offered by a traditional tax credit at the end of year.

3. There's less of an impact on employees from insurance increases, such as premiums, co-pays, deductibles and so on. One of the most common ways for employers to keep benefit costs down is to simply lower the benefit levels of their plan offering. While this saves you money on your premiums, your employees are then faced with greater deductibles, higher co-pays, higher prescription amounts and so on. Through the use of a Health FSA, employees can set aside money to cover these increased amounts, which lessens their out-of-pocket costs because they're setting aside tax-free dollars.

4. Cafeteria Plans allow employees tax savings that they may or may not get filing their yearly taxes. Especially for those that don't itemize deductions

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