How Section 125 Cafeteria Plans Reduce Taxes
While a base salary or wage is a pretty straight-forward concept, compensation in the form of benefits can be complicated because of numerous moving parts.
Most companies now incorporate benefits into an employee’s overall compensation package, and frequently use a Section 125 Plan, or “cafeteria plan” to accomplish this goal.
A Section 125 plan gets its name from the Internal Revenue Code section that permits employees to use pre-tax wages to buy various benefits. The term “cafeteria plan” caught on as another way to describe Section 125 plans because an employee can pick and choose different benefits like choosing different items available in a cafeteria.
The big advantage of Section 125 plans is the tax savings for both the employee and the employer.
Tax advantages for employees
By offering pre-tax deductions for benefits, the employee’s taxable income is reduced thereby reducing their total taxes paid. In the table below, you can see how an employee making $5,000 per check with a $500 insurance premium benefits from having the insurance premium taken out before taxes.
| Without Section 125 | With Section 125 | |
|---|---|---|
| Salary | 5,000.00 | 5,000.00 |
| Pre-tax health insurance | -500.00 | |
| Taxable income | 5,000.00 | 4,500.00 |
| Post-tax health insurance | -500.00 | |
| Social Security Tax – 6.2% | -310.00 | -279.00 |
| Medicare Tax – 1.45% | -72.50 | -65.25 |
| Federal Withholding | -450.00 | -405.00 |
| State Withholding | -170.00 | -153.00 |
| Net Paycheck | 3,497.50 | 3,597.75 |
| Total Taxes Paid by Employee | 1,002.50 | 902.25 |
| Decrease in total tax liability | 100.25 |
By working for an employer who offers a Section 125 plan, the employee will save $100.25 a month in taxes (federal and state withholding amounts are estimated).
Tax advantages for employers
Business owners can also decrease their tax liability by offering Section 125 plans. Here’s how it works from the owners’ perspective:
Businesses must match the Social Security and Medicare payments made by its employees. Therefore, when employees pay more in Social Security and Medicare taxes, the employer also pays more.
Going back to our example, the business saves $38.25 a month in combined Social Security and Medicare taxes by offering a Section 125 plan. Employers might also see additional tax savings in federal and/or state unemployment, depending on the employee’s annual compensation and the state’s wage base for unemployment taxes.
| Without Section 125 | With Section 125 | |
|---|---|---|
| Salary | 5,000.00 | 5,000.00 |
| Pre-tax health insurance | -500.00 | |
| Taxable income | 5,000.00 | 4,500.00 |
| Social Security Tax – 6.2% | -310.00 | -279.00 |
| Medicare Tax – 1.45% | -72.50 | -65.25 |
| Total Taxes Paid by Employer | 382.50 | 344.25 |
| Decrease in total tax liability | 38.25 |
While the tax savings in these examples may not seem dramatic, they can easily add up to thousands of dollars over the course of time. Plus, Section 125 plan documents can very affordably be created, so the savings typically outweigh the setup cost after one or two payrolls are processed.
If you want more information about how Section 125 plans work, don’t hesitate to contact us! We can provide further information, or connect you one of your partners who specializes in Section 125 plan documents.