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Flexible benefits plans.

Flexible Benefits Plans

Doesn't it make sense to help clients save money and improve employee relations at the same time? This can be accomplished by implementing a flexible benefits plan (FBP). This is a Section 125 sanctioned plan whereby certain fringe benefits can be purchased on a tax-free basis. Proposed Regulations (PR) 1.125-1 and PR 1.125-2 allow employees to purchase these benefits with pre-tax dollars, thereby reducing both income taxes and FICA taxes.

Basic Features

Clearly employees can significantly reduce their federal income taxes and FICA taxes by participating in an FBP, but just as important are the significant savings of FICA tax dollars to employers. An employer usually incurs considerable start-up and continuing administrative costs for one of these plans. However, in nearly all cases, the savings in FICA taxes far exceeds these costs, especially in companies with several employees.

FBPs use salary reduction agreements similar to those used for Section 401(k) and Section 403(b) retirement plans. However, an FBP provides permanent tax-free dollars, while taxes on 401(k) and 403(b) monies are deferred to a later date.

The tax-free benefits that can be included in an FBP are group medical insurance premiums, HMO premiums, group dental insurance premiums, reimbursement of out-of-pocket medical and dental expenses, reimbursement of dependent (child) day care expenses, group legal assistance benefits and up to $50,000 of group term life insurance (PR 1.125-2 A-4). This list includes most of the fringe benefits an employer can provide to its employees without increasing their taxable incomes. An employee may select one or more tax-free benefits when he or she signs a salary reduction agreement.

Before each plan year begins, each employee selects which benefits will be purchased through the plan. Once the plan year begins, elections may be changed only if an employee experiences a change in family status (PR 1.125-2 A-6). Also, an employee is usually not allowed to change the amount being contributed to the plan during the plan year for any reason other than approved change in family status (PR 1.125-2 A-7), such as divorce, marriage, death of spouse or child, birth or adoption of child and possibly termination of a spouse's employment.

Furthermore, the amount contributed to a plan must be used in that plan year or returned to the employees, except for monies put in dependent day care reimbursement accounts. Any unused monies in these accounts must be forfeited (PR 1.125-1 A-18).

Each fringe benefit in FBPs must meet all of the related provisions of the income tax laws and regulations, as well as nearly all of the provisions for "cafeteria" plans. One exception is for reimbursement accounts, as non-discrimination rules are relaxed enough so that any employee can freely use them regardless of whether or not other employees do.

FBPs benefit current and retired employees, however self-employed persons cannot participate, and each plan must be approved by the IRS. According to the preambles of the two proposed regulations, an employer may rely on them when drawing up a plan.

Which tax-free benefits should be offered in a salary reduction agreement? Should a plan manager be hired or should the plan be self-administered? How many dollars can employees and employers realistically expect to save implementing an FBP? The answers to these and other questions can only be determined in each specific situation. Nevertheless, the following example can help by providing much of the basic information needed.


The Tennessee Board of Regents (TBR) put an FBP into effect on June 1, 1989, providing group medical insurance premiums, group HMO premiums, group dental insurance premiums, reimbursement of out-of-pocket medical and dental expenses and reimbursement of dependent (child) day care expenses. (While other benefits could have been offered, these are the ones most commonly used.) Before the calendar year begins, each employee elects which parts of the plan he or she wants.

All full-time and part-time regular employees working 30 hours or more per week are eligible to participate; the plan will be administered by a plan manager who will bear the costs of obtaining IRS approval in a private letter ruling, disseminating information to employees and setting up the necessary records.

Group Medical and Dental Insurance Premiums

Medical insurance premiums and HMO premiums are by far the most important items in the package. All employees automatically are included in this portion of the FBP unless they specifically ask to be excluded. Very few employees have asked to be left out. The average amount which is tax-sheltered per month per employee is about $80. The TBR pays a large part of these expenses.

This $960 per year is not subject to FICA taxes. If an employee does not exceed the FICA tax ceiling ($51,300 in 1990), these taxes for both the employee and the employer will decrease by $73.44 (7.65% x $960) per year. The reduction in income taxes for this average employee is either $268.80 ($960 x 28%) or $144 ($960 x 15%), depending on his or her marginal income tax bracket.

Dental insurance premiums can receive the same treatment, but each employee must affirmatively elect this benefit. Relatively few employees have this coverage.

Reimbursement Accounts

A reimbursement account is a fund established by an employee to repay himself or herself with tax-free dollars for specific medical, dental or dependent day care expenses incurred during the plan year. It works like a checking account. The employees make deposits to the account in the form of tax-free salary reductions each regular payday. They then make withdrawals from the account in the form of reimbursement requests. This allows employees to pay these expenses with tax-free dollars.

Medical Expense Reimbursement Accounts

Medical expense reimbursement accounts are used to reimburse employees for out-of-pocket medical and dental costs allowed by the Internal Revenue Code (IRC) and regulations. The amount reimbursed cannot exceed the funds in an employee's individual account. The TBR plan provides that if any funds are in an employee's account at the end of the plan year, they are forfeited to the employer. Other organizations have plans which allow these amounts, within reason, to be refunded to the employees.

How much can an employee contribute to a medical expense reimbursement account? The IRC and regulations do not specify a maximum amount, but the TBR plan limits contributions to $2,400 per year. To avoid forfeitures, employees should limit contributions to amounts they are sure to use.

As long as an employee's pay remains below $51,300 for a year, the employee and the employer will each reduce their taxes by 7.65% of the amount deposited. For example, if an employee using the TBR plan contributed the full $2,400, both the employee and the TBR would save $183.60 ($2,400 x 7.65%) in FICA taxes per year.

Also, the employee can reduce his or her income taxes by as much as $672 ($2.400 x 28%) or $360 ($2,400 x 15%), according to his or her marginal income tax bracket. These maximum savings will only be realized by employees who (a) do not itemize their deductions or (b) do not have enough out-of-pocket medical and dental costs to overcome the 71/2% floor for deducting these costs. Those employees who do itemize their deductions, including the medical deduction, will realize no income tax savings.

Obviously, there are degrees of saving between these extremes.

Dependent Day Care Reimbursement Accounts

Dependent day care reimbursement accounts are used to reimburse employees for eligible expenses incurred during the plan year that enable the employees and their spouses to be gainfully employed. The costs reimbursed must be for the payment of dependent (child) day care expenses specified by the IRC.

How much can employees contribute to dependent day care reimbursement accounts? In most cases, the TBR plan allows them to contribute up to $5,000 per year if they are a single parent or married and filing a joint return. Their maximum pre-tax contributions are lower if one of the following conditions apply: 1. If they are married but file

separate returns, they can

contribute up to $2,500 per year. 2. If either they or their spouses

earn less than $5,000 per year,

they can contribute an amount

equal to the lower of the two


When is a dependent day care reimbursement account beneficial? It is always beneficial to the employer. The employer will save 7.65%, the FICA tax rate, of the amount deposited as long as the employee's pay is less than $51,300 for 1990. The maximum FICA tax saving per employee is thus $382.50 ($5,000 x 7.65%).

Employees sometimes will and sometimes won't benefit from using these accounts. If an employee establishes a dependent day care reimbursement account, he or she cannot claim the child care tax credit when filing his or her tax returns unless the tax-free contributions made to the reimbursement account are less than $4,800. A small tax saving on the $200 ($5,000 - $4,800) is available to all TBR employees.

In all cases, the tax savings an employee receives through a dependent day care reimbursement account exceed the taxes saved by claiming the child care tax credit if the employee's marginal income tax rate is 28%. This is because the 35.65% (28% + 7.65%) combined tax rate is greater than the highest child tax credit rate.

However, in most cases, claiming the tax credit is better if the employee's marginal income tax rate is 15%. The child care tax credit rate ranges from 29% to 20%. Thus it is usually, but not always, greater than the 22.65% (15% + 7.65%) combined tax rate of those whose marginal income tax rate is 15%.

A sizeable number of state employees whose taxable income is less than but near the bottom of the 28% income tax bracket could benefit from using dependent day care reimbursement accounts, especially if they can also save both federal income and FICA taxes on the $200 ($5,000 - $4,800). The best choice in many marginal cases must be calculated on a case-by-case basis because the calculation of a cut-off point is not possible since the dependent (child) day care tax credit rate is determined on the basis of adjusted gross income, not taxable income.

Compliance with Fringe Benefits Nondiscrimination Rules

The TBR Flexible Benefits Plan as described here has been accepted by the IRS. This means that the plan meets the nondiscrimination rules. It would appear then, that any employer would receive automatic approval for a plan fashioned after this plan. This assurance is important because compliance with nondiscrimination rules remains treacherous grounds even after the repeal of Section 89.

Benefits and Costs to Employers

The TBR pays a plan manager to administer its plan. The approximate cost per month is $1.30 for one benefit option per employee, $2.60 for two benefit options per employee and $3.25 for three or more benefits options per employee. Almost all employees are participating in the medical insurance or HMO premiums plan, and about 5% of them have reimbursement accounts. For convenience, since few do, we assumed that no employee has two reimbursement accounts. We also ignored the few who have dental insurance.

The TBR has about 10,000 employees. The average annual deduction per participant in the insurance premiums plan is about $960. The average annual deduction for reimbursement accounts is much higher, say $3,200, since they are commonly used for child care expenditures. It is also assumed that no employee makes over $51,300 per year. Based on this information and these assumptions, the net benefit per year to the TBR is as shown in Table 1.

As can be seen, the TBR enjoys a substantial reduction in costs from this plan. And greater savings will probably occur as the number of employees using the reimbursement accounts increases. This increase should take place as employees become more familiar and comfortable with these accounts.

The substantial FICA tax savings a large organization employing thousands of people can obtain is obvious from the TBR example. However, small businesses can also benefit from an FBP. For example, assume a business only has 25 eligible employees, the average salary reduction is $2,000 per employee and no employee makes more than $51,300 per year. The employer would reduce its FICA taxes by $3,825 ($50,000 x 7.65%). Even if it cost $50 per employee per year to administer the plan, a total of $1,250, the employer would still enjoy a net benefit of $2,575 ($3,825 - $1,250). Although this net benefit is modest, it does improve profitability by $2,575. And not to be forgotten are the employees who are also enjoying FICA and federal income tax savings.

Effects on Social Security Benefits

Some employees might be concerned about reduced Social Security benefits upon retirement as a result of these salary reduction arrangements. They should be assured that in the vast majority of cases, paying less FICA taxes has only a very small effect upon the amount of Social Security benefits that an employee receives. Almost all retired employees receive very little benefit from taxable pay. A few employees who have pay subject to FICA taxes for only a few years of their lives do need to be concerned about this matter.

Survey Results

The authors recently distributed a questionnaire to those attending an income tax CPE course. The 45 participants were asked for certain information about salary reduction agreements their clients or employers had in effect. Only eight responded that they did have these.

The authors realize that such a small group and a very limited response does not necessarily give representative information, but the results are interesting. They are as follows:

1. The benefits offered ranged

from one employer who only

offered tax-free benefits for

medical insurance to an

employer who offered eight

different options. 2. Every respondent except one

indicated that the employer's

saving from their FBP was

more than the cost of

administering the plan. The one

exception stated that he did

not know whether or not there

was a net saving. 3. One participant indicated that

an additional saving was a

reduction in the costs of

providing previously fully paid

fringe benefits.


A flexible benefits plan almost always reduces the income taxes and FICA taxes of employees by allowing them to purchase certain fringe benefits with tax-free dollars. Since most employees make less than the maximum wages per year subject to FICA taxes, employers' FICA taxes will always be reduced. This benefit to employers will be reduced by start-up costs and the costs of administering the plans, but in almost every case the employers' tax savings will exceed these costs.

This article discussed the TBR plan and the substantial tax savings achieved by the TBR and its employees, thereby illustrating a plan which other organizations and their employees can use and the tax savings which can be realized.

Other organizations are already realizing benefits from salary reduction arrangements. The logical conclusion is, for nearly all organizations, that the only way to lose on a flexible benefits plan is not to have one. [Tabular Data Omitted]

Kenneth R. Lea is associate professor of accounting at Tennessee State University in Nashville, Tennessee. He is a certified public accountant in Florida and Tennessee and received his doctorate of business administration from Louisiana Tech University in Ruston, Louisiana. He has published articles in the Tennessee CPA and the Proceedings of the Southeastern Regional Meetings of the American Accounting Association. Louis Mullen is professor of accounting and business Law at Tennessee State University in Nashville, Tennessee. He received his undergraduate degree from the University of Georgia and his masters and PhD from the University of Illinois. He has published articles in numerous professional journals, including The Practical Accountant, the Journal of Accountancy and the National Public Accountant.
COPYRIGHT 1990 National Society of Public Accountants
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1990 Gale, Cengage Learning. All rights reserved.

Article Details
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Author:Lea, Kenneth R.; Mullen, Louis E.
Publication:The National Public Accountant
Date:Jun 1, 1990
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