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May 10, 2023 ConnectPay

What is a 125 Plan? Plus How it Works With an HSA

What is a 125 Plan? Plus How it Works With an HSA

Offering benefits plans to your employees is an excellent way to retain your best talent.

But the world of benefits plans can be hard to navigate. One plan to consider is Section 125 or the cafeteria plan. Started in 1978, it offers various benefits and opportunities to employees. But how does it work?

This article highlights what a 125 Plan is, how it works, and the benefits and opportunities you can pass to your employees.

Is a 125 Plan the Way to Go?

A 125 plan can be an excellent choice for many employers and employees due to its flexibility and tax-saving advantages.

Before deciding whether a 125 Plan is the way to go, it’s essential to carefully consider your organization's needs, budget, and workforce demographics. Additionally, 125 Plans may require additional administrative responsibilities and costs, and you should comply with the law and regulations.

At ConnectPay, we pride ourselves on simplifying payroll for small businesses. We ensure you’ll never have to worry about the IRS again. From automated payroll tax reporting to pre-tax benefits for you and your employees, we work with you or your bookkeeper to ensure your payroll taxes are filed correctly and on time.

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What is a 125 Plan?

A cafeteria plan is a reimbursement plan governed by IRS Section 125. It allows employees to contribute some of their gross income to a designated account or accounts before taxes are calculated.

Employees can allocate a portion of their salary toward specific benefits, such as health insurance premiums, dependent care, or flexible spending accounts before taxes are deducted. By doing this, employees can save money on taxes while still being able to access their benefits.

Why cafeteria? Cafeteria plans allow employees more flexibility and choice to customize their benefits packages to meet their needs.

Let’s look at the various benefits of a 125 Plan.

The Benefits of a 125 Plan

For the employee:

  • Lower taxable income: Employees allocate some of their income to benefits before taxes are deducted, reducing their taxable income.
  • Higher take-home pay: The lower taxable income allows employees to keep more of their earnings and enjoy valuable benefits.
  • Customizable benefits: Employees can choose from various benefits options with Cafeteria Plans. They’ll feel valued and supported.
  • Financial and savings opportunities: Investing in Health Savings Accounts (HSAs) can contribute to long-term financial stability, allowing employees to grow their balances over time.

For the employer:

  • Reduced payroll taxes: Employers can also benefit from tax savings since employees' pre-tax contributions reduce taxable payroll.
  • Lower employment costs: These tax savings can help employers manage their budgets more effectively.
  • Employee wellbeing: A 125 Plan can contribute to happier, healthier, and more productive employees by offering benefits that support physical and mental well-being, as well as work-life balance.

What is an HSA?

A Health Savings Account (HSA) is a tax-advantaged account that lets employers and employees make tax-free contributions to pay for certain out-of-pocket medical expenses.

There are three main advantages to an HSA account:

  1. Triple tax benefits are available to account owners. An HSA allows for tax-deductible contributions, tax-free earnings, and tax-free withdrawals for qualified medical expenses.
  2. Employees own HSAs, so they can take the account with them if they change employers or leave the workforce.
  3. Unlike Flexible Spending Accounts (FSAs), HSA balances roll over yearly, allowing employees to accumulate savings for future medical expenses, including retirement.

How do 125 Plans and HSAs Work Together?

These two plans work together to maximize their benefits to a company and its workers. Suppose you offer employees a Section 125 plan and an HSA. In that case, you’ll need to include the plans as part of your annual enrollment period, so eligible employees can sign up, maximize usage of your benefits, and save money on taxes.

You can withhold employee pre-tax earnings and have employees contribute them to their HSA. This is a cafeteria plan — the funds are the employees’ and are a part of their paycheck. You enable the contribution through your payroll system.

What are the Advantages of Saving in an HSA?

Among the advantages of saving in an HSA is that cafeteria plans reduce the taxes employees pay. Employees file Form 8889 to be credited for income tax they paid. HSA contributions are taken automatically from paychecks, so offering a cafeteria plan gives employees pre-tax payroll deferrals to their HSAs. 

It’s inexpensive and can be a good option for employees. You benefit by not having to pay payroll taxes on your employees’ HSA contributions.

  • Employees can make HSA contributions through payroll deferral on a pre-tax basis.
  • Employees may pay their share of insurance premiums on a pre-tax basis.
  • You and your workers save payroll taxes.

Contributions to HSAs under Section 125 plans are subject to nondiscrimination rules — the plan cannot favor highly compensated or key employees. Violations generally do not result in plan disqualification, but the value of the benefit may become taxable for highly compensated or key employees.

From 125 Plans to Everything Tax: Don’t Go It Alone

If you aim to save on payroll taxes, offering cafeteria plans governed by Section 125 for HSA contributions is the way to go. With a small investment of money and time, you can add a Section 125 plan allowing for pre-tax deferrals. 

Besides, you save on your share of payroll taxes for the pre-tax amounts taken, which will likely offset the costs of setting up the plan.

Many brokers will prepare documentation establishing a cafeteria plan at no extra cost to employer clients, but it’s always a good idea to have counsel review the documentation.

Employees keep a larger slice of their earnings, while you benefit by not having to pay payroll taxes on the employees’ HSA contributions. HSA contributions aren’t counted as income for federal and, in most cases, state income taxes. Setting up automatic payments generally simplifies and improves employee savings.

At ConnectPay, we’re always ready to connect you with brokers and local tax experts who can help you decide whether a 125 plan is the way to go. Reach out today for a free payroll and tax compliance review. Alternatively, check out our free resource, The Connected Guide to Small Business Payroll.

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Published by ConnectPay May 10, 2023