Wages, salaries and commissions typically represent only a portion of an employee's total compensation. Paid time off and employer contributions toward a qualified retirement program are significant factors, but one of the most important employee fringe benefits is the availability of health insurance coverage. In addition to contributing to the employee's peace of mind, qualifying health insurance premiums that are withheld from payroll may be made with pre-tax dollars.
The Internal Revenue Service considers all income from all sources, regardless of whether the income comes in the form of money, goods, services or other fringe benefits, to be taxable unless it is specifically exempted from taxation by law. The IRS can consider the value of health insurance premiums that an employer pays for an employee to be a taxable fringe benefit that must be included in the employee's taxable pay. In practice, though, most employees pay no taxes on their medical insurance premiums, whether they or their employees actually pay the premiums.
A Section 125 plan, commonly referred to as a cafeteria plan, offers an exception to the taxable income provision for employee fringe benefits. Under section 125 of the Internal Revenue Code, an employer may establish a separate written plan that allows the company's employees to receive certain fringe benefits, including health insurance, on a pretax basis. This is the only method available to employers by which they can provide their workers with a choice between pretax and after-tax benefits without resulting in the benefits becoming taxable.
Pretax vs After Tax
The primary employee benefit of choosing pretax health insurance deductions is the reduced cost due to income tax savings. Employees can deduct the amounts they pay toward their own medical insurance premiums from their taxable pay, and they are not taxed for the premiums that their employers pay on their behalf. Under such a plan, the company can also take a tax deduction for the premiums it pays on behalf of its employees.
Not all employer-sponsored health insurance plans qualify as Section 125 plans. Non-qualified plans are paid with after-tax dollars. Any amount withheld from the employee's paycheck to pay for insurance premiums under non-Section 125 plans must be included in the employee's pay and is subject to federal income taxes. Most employees are covered by qualified health insurance plans -- if they are covered by health insurance at all at work. Plans generally fall into the non-qualified category only if they are deemed under IRS rules to be discriminatory in the sense that they grant significantly greater insurance benefits to some employees than to others. Even though non-qualified plans are not deductible under Section 125 rules, employees may still be able to deduct their premium expenses under the rules that govern medical expense deductions. However, the medical expense deduction only applies to medical costs that rise above 7.5 percent of an employee's adjusted gross income, so most employees will enjoy a greater tax benefit if a Section 125 plan is available.
- Internal Revenue Service: Publication 502, Medical and Dental Expenses
- Harvard University Office of the Comptroller: Understanding Your W2 Wages
- Internal Revenue Service: Publication 15-B, Employer's Tax Guide to Fringe Benefits
- Internal Revenue Service:FAQs for Government Entities Regarding Cafeteria Plans
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