The DOL is targeting employers’ Section 125 cafeteria plans with an increase in audits.
Section 125 allows employers to offer a wide assortment of benefits – everything from HSAs and FSAs to dependent care assistance – on a pre-tax basis.
And while that arrangement may seem convenient for employers and employees alike, many firms fall short when its comes to the plans’ compliance and administration obligations.
Critical 3-pronged test
The tax-break that goes along with Section 125 requires employers to meet nondiscrimination rules that keep plans from favoring highly compensated or key workers.
And that’s an area where it’s easy for firms to get into compliance trouble.
In a nutshell, a nondiscrimination test covers three areas:
- Eligibility – testing to see if too many non-highly-compensated or non-key employees are ineligible
- Availability – testing to see if highly-compensated/key employees have access to more or better benefits than rank-and-file staffers, and
- Utilization – testing to see if highly-compensated/key employees elect more benefits under the plan.
The utilization component – an area that changes from year to year and must be tested at least annually for compliance – generally gives employers the most problems.
Here’s an example of how problems can occur: Say a company offers a dependent care assistance plan. While all employees are eligible, the highly compensated staffers are the only employees who take advantage of the plan.
Employers should test for utilization early in the plan year and make any adjustments before the end.
Reason: If a plan is discriminatory, the value of the plan’s benefits that
fail the test must be included as taxable income — not what employers want at the end of the plan year.
Consider ‘pre-tax’ impact
Employers also need to be aware of when pre-taxing benefits can sometimes hurt employees. For example, disability insurance can be paid on a pre-tax basis. But when that happens, the benefit is taxable when it’s paid out.
Here’s the issue: Employees are already only getting 60% of their salary through disability and tend to need money the most when they’re out.
If those benefits are taxed when they’re paid out, it can leave employees short of what they need.
Adapted from: “Why the Section 125 cafeteria plan needs a second look,” by Harrison Newman.