As health care costs continue rising and employees are being asked to shoulder more of the expense burden, you can help them by offering a tax-advantaged plan that allows them to save for medical expenses.

These cafeteria plans, which are governed by Section 125 of the Internal Revenue Service Code, allow your employees to withhold a portion of their pre-tax salary to cover certain medical or childcare expenses. Employees can save an average of 30% in federal, state and local taxes on items they already pay for out of pocket.

Because these benefits are free from federal and state income taxes, an employee’s taxable income is reduced, which increases the percentage of their take-home pay. 

The plans benefit employers, as well. Since the pre-tax benefits aren’t subject to federal social security withholding taxes, employers don’t have to pay FICA or workers’ comp premiums on those payments. A cafeteria plan can save employers an average of almost $115 per participant in FICA payroll taxes.

Types of cafeteria plans

Premium-only plan: POP plans allow employees to elect to withhold a portion of their pre-tax salary to pay for their premium payments. Most companies currently have this set up through their payroll provider. A POP plan is the simplest type of Section 125 plan and requires little maintenance once it’s been set up through your payroll.

Flexible spending account: With an FSA an employee pays — on a pre-tax basis through salary reduction — for out-of-pocket medical expenses that aren’t covered by insurance (for example, annual deductibles, doctor’s office copayments, prescriptions, eyeglasses and dental costs). 

Dependent care flexible spending account: The dependent care FSA is an attractive benefit for employees who pay for childcare or long-term care for their parents. Employees may hold back as much as $5,000 annually of their pre-tax salary for dependent care expenses, which include expenses they pay while they work, look for work or attend school full-time.

How an FSA works

Before the start of the year, employees estimate how much they expect to spend on medical expenses and dependent care over the course of the year. 

Employees should be careful to not put too much into the account. (They can carry over $500 in unused funds from the prior year into the new year, but any funds in excess of that would be forfeited.) 

Whatever amount they choose to deduct for the year will be deducted on a pro-rated basis from each paycheck and deposited into their FSA. 

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.

Employees pay out-of-pocket expenses upfront and then submit a claim and documentation to the plan administrator. They are then reimbursed for their expense in the form of a check or account transfer.

Q: We have an employee who wants to make changes to her cafeteria plan election, even though benefits are already effective. Is there a grace period that allows her to change her election?

Employers: Don’t make this common cafeteria plan mistake!

Once cafeteria plan benefits become effective, the elections are “locked in.” Employees cannot change their minds and make changes to pre-tax cafeteria elections during the plan year, once benefits become effective — unless a special enrollment period as defined under IRC Section 125 applies, or the employer is correcting an administrative error.
Many group health insurance plan sponsors and administrators have the mistaken belief that the law allows employees enrolling in Section 125 cafeteria plans to change their elections, as long as they do so within 30 days of the plan becoming effective.

This is not correct. And this misconception can have serious consequences. It can even jeopardize the tax-favored status of the entire plan.

The facts

While most insurance carriers and cafeteria plan benefit vendors allow for changes to employee pre-tax elections in cafeteria plans within 30 days, the IRS does not.

Once coverage becomes effective, the elections are irrevocable. Employees cannot change their minds during the plan year outside of a special enrollment period authorized under Section 125. Examples include a change in marital status, change in employment, reduction of work hours, enrollment in a qualified health plan, among others.

The IRS has issued informal guidance that employers can correct an administrative error without jeopardizing the plan’s tax-favored status. But there must be “clear and convincing evidence” that the change in election is being made to correct an administrative error.

An employee changing his or her mind does not count.

The consequences

If an employer makes a change to an employee’s cafeteria plan election, there’s no applicable special enrollment provision such as a change in marital status, and there’s no clear and convincing evidence of an administrative error, the IRS may disallow the entire plan.

That means the tax benefits of your Section 125 cafeteria plan will disappear, resulting in income tax liability for the worker.