Participation in "Cafeteria" Plans.

• Author: Cavanaugh, Thomas J.
• Position: Pension and Benefit Report

A benefits alternative for some employees is to pay for a selection of benefits through a flexible benefits plan. These "cafeteria plans" are permitted under Section 125 of the Internal Revenue Code, which enables employers to create plans providing participants the ability to choose between cash wages and certain tax-free benefits. In the public sector, Section 125 plans have been used mainly to establish tax-free benefits that are financed entirely by employees through salary reduction.

Three types of benefits, or accounts, often are included in such public sector plans:

* Dependent Care Account (DCA): money set aside before taxes to pay for day care and other qualifying dependent care expenses that are incurred so as to permit the participant to work.

* Medical Expense Reimbursement Account (MRA): money set aside before taxes to pay for eligible medical care expenses not met through other benefits.

* Health Care Premium Conversion Account (PCA): the mechanism by which participant health care premiums for group coverage are paid on a before-tax basis.

In addition to the employee savings in federal (and possibly state and local) income taxes, both employees and employers avoid Social Security taxes on amounts deferred to a Section 125 plan.

There is an Internal Revenue Service (IRS) restriction that applies to the utilization of these accounts, known as "use-it-or-lose-it." Participants are required to establish the amount of deferral to each account before the plan year begins. Those amounts cannot be changed during the plan year except for IRS-approved family status changes. If the entire deferral is not used on approved expenses incurred during the plan year, any monies remaining in a participant's account are forfeited to the employer. Although this restriction is a concern, with proper planning losses can be greatly minimized and, in nearly all instances, avoided altogether.

Because of the tax revenue loss associated with Section 125 plans, most of the current health care reform proposals debated in Congress call for the elimination of these plans as they pertain to health expenses. Dependent Care Accounts would not be impacted by the current reform proposals. Aside from the revenue loss, the main reason given for their elimination is that these plans primarily benefit highly compensated individuals.

In order to demonstrate the current Section 125 usage in the public sector, Gabriel, Roeder, Smith & Company conducted a study of...