Using a Cafeteria Plan
Cafeteria plans are another employee benefit that offer tax breaks. Cafeteria plans are also called flexible spending accounts or Section 125 plans after the section of tax code that governs their use.
Cafeteria plans earn their nickname from the flexibility they give you in choosing from a menu of benefits. With a cafeteria plan, you authorize your employer to deduct a fixed amount or percentage from your before-tax income.
Cafeteria-plan contributions are made to a reimbursement account that is used to pay for qualified expenses that you expect you will incur during the year. Qualified expenses include health care, dependent care and group life insurance premiums that your employer does not reimburse. Qualified health care expenses include insurance premiums, deductibles and copayments.
The two main types of reimbursement accounts are dependent care and health care reimbursement accounts. While there are no federal limits on how much you may set aside, the normal employer-mandated limit is $2,500 or $5,000 a year.
Your contributions to a cafeteria plan are exempt from federal income taxes and payroll taxes. Since employers also do not have to pay their one-half share of payroll taxes on your contributions to a cafeteria plan, they are often amenable to setting up a cafeteria plan.
Let's calculate the potential household savings from using a cafeteria plan. A married couple with two children earns combined gross income of $80,000. They anticipate total unreimbursed health- and dependent-care expenses for 2008 to be $10,000.
The couple calculates they may be able to save up to $4,000 in income taxes by participating in their employers' cafeteria plans. As a result, each spouse opens a dependent and health care reimbursement account for $2,500 each, reducing their combined taxable income by $10,000:
|Using a reimbursement|
|Not using a|
|Less: Contributions to reimbursement accounts||$10,000||$0|
|Less: Payroll taxes (7.65%)||$5,355||$6,120|
|Less: Federal income taxes (25% for 2008)||$17,500||$20,000|
|Less: State income |
|Less: Qualified |
|Take-home pay after expenses||$43,645||$39,880|
|Savings from reimbursement|
It's important to remember that reimbursement accounts are use-it or lose-it accounts. That means you have to estimate, as closely as possible, how much you expect to pay in either category of expenses. (Group life insurance premiums not paid by your employer also qualify as an expense for cafeteria plans.) Any unused funds at the end of the year are forfeited.
Generally, you can only designate once a year how much you want your employer to withhold for your reimbursement accounts. Exceptions to this rule include marriage and birth of a child.
A similar type of tax-deferred account used to pay for health care expenses through 2003 was an Archer MSA. Archer MSAs were formerly called medical savings accounts and have been replaced by Health Savings Accounts (HSA) beginning in 2004. Health Savings Accounts are tax-favored accounts for self-employed persons and employees of small companies that pay for their health insurance with higher-than-average deductibles. Funds held in an Archer MSA may be transferred into a new Health Savings Account.
For 2008, single persons using a Health Savings Account must have a minimum annual deductible of $1,950. For families, the minimum deductible is $3,850. Maximum annual deductibles for single and married persons are $2,900 and $5,800, respectively. Maximum out-of-pocket expenses for the year for single and married persons are also $3,850 and $7,050, respectively.
If you use an Archer MSA, you must complete IRS Form 8853. For an HSA, you must use IRS Form 8889. For more information, see IRS Pub. 969. MSAs were originally introduced as a pilot program and scheduled to expire after 2000. The Tax Relief and Health Care Act of 2006 extended the use of Archer MSAs to the end of 2007, after which no new MSAs may be created.