What’s on the menu?
Changes in Section 125 cafeteria plans

Section 125 plans, better known as cafeteria plans, offer employees an opportunity to participate in health insurance and other employer benefits on a pretax basis. Pretax means the contributions are deducted from the employee’s paycheck before payment of federal income tax. Starting in January 2009, new regulations will apply to these types of plans.

What are cafeteria plans?

Sec. 125 plans allow employees to pay medical, dental and vision premiums on a pretax basis, so that these amounts are excluded from the gross income of the employee. Plans can include benefits such as health insurance, dental insurance, long-term and short-term disability insurance and life insurance, to name a few. Such plans can also provide dependent care benefits on a pretax basis.

Employers can offer participants three options for having money deducted from their pay: They can pay the insurance premiums on a pretax basis, participate in a flexible spending account, or offer a dependent care arrangement. Employees may choose any of these options. With a flexible spending account, also known as a medical reimbursement feature, participants elect to make deferrals on a pretax basis and get reimbursed for out-of-pocket healthcare-related expenses. Plans may also have a pretax dependent care component where participants elect to have dependent care expenses reimbursed.

What do you need to know?

The regulations clarify many prior rulings that were somewhat vague. The major areas impacting sponsors include:

One of a kind. A Sec. 125 plan is the only program that allows an employer to offer employees a choice of taxable and nontaxable benefits. Any election made outside of a Sec. 125 plan will result in gross income to the participant.

Change in status. Employees elect to participate in the Sec. 125 plan and choose their benefit options before the beginning of the plan year. Participants can change their elections only for major life events such as change in marital status, birth, or change in working hours such as full time to part time. 

Time of reimbursements. Plans can reimburse participants for only qualified benefits that correspond to the participant’s current plan-year elections. The coverage period must equal the current plan-year elections for any payments to be qualified benefits.

Forfeiting unused money. Participants will forfeit unused amounts at the end of the plan year. Plans with a flexible spending component may allow for a grace period of up to two-and-a-half months after the plan year. During this time a participant may incur expenses for amounts deferred in the previous plan year.

Plan document. The regulations reiterate that a cafeteria plan must have a written plan document and the plan must operate in accordance with plan terms. Plan sponsors must provide election forms and a summary plan description to participants.

Debit cards. Plans may use a debit card system to reimburse employees for medical costs. The regulations state that employees must sign a written election agreeing to use the card for unreimbursed medical expenses and can’t seek reimbursement from another health plan. You can limit the card use to certain providers or merchants.

The menu looks good

The new regulations also further clarify discrimination testing issues and define key and highly compensated employees so that they are more in line with the qualified plan definition. These regulations should help clarify the gray areas in the legislation and provide a framework for an effective Sec. 125 program. •