Payroll - cafeteria plan deductions

🇺🇸 Payroll deduction, also called a cafeteria plan or Section 125 plan (after the relevant Internal Revenue Code section) allows benefits such as health insurance to be paid by your employer and not counted in your salary. For example, if you have a $100,000 salary and have $5000 paid by payroll deduction, your Form W-2 will list a salary of $95,000; if you do not use payroll deduction, your Form W-2 will list a salary of $100,000, but you might be able to deduct the $5000 if the tax laws allow it to be deducted. Your employer may give you the option to take some of these benefits (thus the name "cafeteria plan"), and if you do take them, you may have the option to use payroll deduction.

Eligible benefits
The full list of eligible benefits is in IRS Publication 15-B, Employer's Tax Guide to Fringe Benefits. The most common examples are health insurance, group life insurance up to a $50,000 benefit (anything above that is taxable to the employee if paid by the employer), Flexible Spending Accounts for health and dependent care, and Health Savings Accounts.

Value to the employee
Since benefits paid by payroll deduction reduce your salary, they are exempt from federal income tax (and tax in most states). Even if the benefit is deductible as an itemized deduction, payroll deduction may reduce your tax, because some tax benefits such as the child tax credit phase out based on adjusted gross income; having the benefit subtracted from your salary reduces your adjusted gross income, while deductions are used in computing your taxable income from your adjusted gross income.

In addition, some benefits may not be deductible; for example, medical expenses such as health insurance are only deductible if you itemize deductions and they exceed a percentage of your adjusted gross income.

Social Security
Most benefits are also exempt from Social Security and Medicare tax. Exemption from Social Security tax is not necessarily a benefit; if you pay less in Social Security tax, you will have lower Social Security benefits. As a result, if the only tax savings from payroll deduction is the 7.65% reduction in Social Security and Medicare tax, payroll deduction is close to break-even if you have high income, and a loss if you have low income.

To estimate the difference in the benefit, you need to check the Social Security benefit formula. Your Averaged Indexed Monthly Earnings (AIME) is your average monthly salary over your 35 highest-earning years, adjusted for wage growth over time; therefore, a $420 payroll deduction reduces your AIME by $1 (adjusted for wage growth).

If you have high AIME (over $6002 in 2021, corresponding to an annual $72,024; over $6172 in 2022, corresponding to an annual $74,064), your Primary Insurance Amount (the monthly benefit you receive at full retirement age) is reduced by 15 cents (indexed for inflation after you start receiving benefits) if your AIME is decreased by $1. The $420 benefit saves you $32.13 in Social Security and Medicare tax, so it takes 214 months (about 18 years) of benefits to break even if the reduced Social Security and Medicare tax is all you save. The actual break-even time is slightly longer because 85% of the benefit will probably be taxed; however, the reduced benefit also reduces your potential disability benefit, and your spousal and widow(er)'s benefit if you are married.

If you have lower AIME, your PIA is reduced by 32 cents if your AIME is decreased by $1, so it takes 100 months (about 8 years) to break even with the Social Security and Medicare tax reduction. The payroll deduction for Social Security is probably a net loss.

If you are over the maximum earnings taxed by Social Security ($137,700 in 2020, $142,800 in 2021, payroll deduction does not affect your Social Security tax or benefits, but it does save you the 1.45% Medicare tax.

Health insurance
If you would not otherwise be able to deduct an expense, payroll deduction provides a substantial benefit. This is the reason for health care Flexible Spending Accounts; if you cannot deduct your medical expenses, an FSA allows you to pay medical costs with pre-tax dollars, saving you $625 for a $2500 FSA in a 25% tax bracket. Likewise, you will get a substantial tax benefit if your employer allows you to use payroll deduction for health insurance; you will save 25% of the premium.

Health Savings Account
Contributions to a Health Savings Account are always subtracted from your income. They are subtracted as an adjustment to income, rather than an itemized deduction, which means that they lower your adjusted gross income. Therefore, the only benefit from payroll deduction is the savings on Social Security and Medicare tax.

With Social Security and Medicare as the only tax benefit, payroll deduction for a Health Savings Account is close to break-even if you have high income but are under the Social Security maximum taxable income, as computed above. If you do not have high income for your career, do not use payroll deduction for your HSA; if you are over the Social Security maximum, there is a small but clear benefit.

Child and dependent care
You cannot claim the child and dependent care benefit using expenses paid by your employer, including through a dependent care Flexible Spending Account. You should compare the tax savings from the FSA (which are at your tax rate) to the credit (which is at a rate that decreases with your income; see IRS Publication 503, Child and Dependent Care Expenses). Usually, it is better to use the FSA if you are in the 25% or higher tax bracket, as the credit is likely to be about 20% and the Social Security tax won't cost too much.

Highly compensated and key employees
Employer cafeteria plans which favor highly compensated employees as to eligibility to participate, contributions, or benefits, must include in their wages the value of taxable benefits they could have selected. A plan maintained under a collective bargaining agreement does not favor highly compensated employees.

Employer cafeteria plans which favor key employees must include in their wages the value of taxable benefits they could have selected. A plan favors key employees if more than 25% of the total of the nontaxable benefits provided for all employees under the plan go to key employees. However, a plan maintained under a collective bargaining agreement does not favor key employees.

A key employee is generally an employee who is either of the following:


 * An officer having annual pay of more than $185,000 for 2021, $200,000 for 2022
 * An employee who for that year is either of the following.
 * A 5% owner of your business.
 * 1% owner of your business whose annual pay was more than $150,000.