Payroll - cafeteria plan deductions

🇺🇸 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 $5,000 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 $5,000 on your tax return 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.

This page focuses on non-retirement benefits typically available by cafeteria plan deduction, and whether you should take them. For payroll deduction calculations generally, including taxes and retirement plans, see: Payroll deductions.

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
In some cases, cafeteria plan deductions are subsidized by the employer. For example, an employer-sponsored health insurance plan may cost the employee $2,000 per year via payroll deduction, but the employer may also contribute a similar amount, or possibly much more, to pay the full cost of the plan. Aside from tax consequences, this is a very valuable option to the employee, who would have to pay much more out-of-pocket to purchase a plan of similar quality on the open market.

Tax consequences
Because benefits paid by payroll deduction reduce your salary, they are exempt from federal income tax (and income tax in most states). For benefits that would otherwise not be tax-deductible, this represents a significant tax savings.

Health insurance premiums paid directly to an insurer, not through a cafeteria plan, are deductible as medical expenses below-the-line on IRS Form 1040 Schedule A. However, this is much worse than an above-the-line deduction like a payroll deduction, for these reasons:


 * Below-the-line deductions are only available to those taxpayers who itemize deductions, which is not common due to the large standard deduction. As of 2019 only about 14% of taxpayers itemized deductions
 * Medical deductions are subject to a 7.5% AGI floor, meaning only expenses exceeding 7.5% AGI are deductible
 * Below-the-line deductions do not reduce AGI, which is used to calculate phase-outs of many tax credits, such as the Child Tax Credit and the Saver's credit

This same reasoning also applies to planned medical expenses paid with a Health Savings Account or Flexible Spending Account, although the use-it-or-lose-it nature of a FSA needs to be weighed against the potential tax savings.

Even in cases where payroll deductions are otherwise deductible above-the-line, such as with HSAs, there may still be tax consequences for deducting through payroll versus directly on the individual tax return. For example, Earned Income Tax Credit (EITC) calculations consider the difference between earned income (Form W-2 box 1) and AGI. Likewise, Expected Family Contribution (EFC) calculations are also affected, and while not technically a tax, it behaves as a tax. It's best to check for potential tax impacts with a software tool or asking your accountant.

Social Security
Most benefits are also exempt from Social Security and Medicare tax, typically a 7.65% tax savings. Exemption from Social Security tax is not necessarily a benefit; if you pay less in Social Security tax, you might have lower Social Security benefits. 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). Your baseline future monthly benefit, called the Primary Insurance Amount (PIA), is calculated from AIME using three brackets: 90%, 32%, and 15%.

Taxpayers who expect to be in the 15% bracket (average annual wages over $80,652 as of 2023), 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 rate of return of Social Security tax is around 0 or negative, and is likely much worse than what can be expected from traditional investments. So, Social Security tax is usually best avoided. However, the reduced benefit also reduces your potential disability benefit, and your spousal and widow(er)'s benefit if you are married.

Taxpayers who expect to be in the 32% bracket (average annual wages between $13,380 and $80,652 as of 2023) can expect a modest rate of return on the taxes paid, which depends mostly on age, gender, and health, but also other factors; see the main article for details on whether payroll taxes should be avoided in this case.

Taxpayers who expect to be in the 90% bracket (average annual wages below $13,380 as of 2023) can expect a very good rate of return on the taxes paid, and as a general rule should not avoid payroll tax where possible.

If you are over the maximum earnings taxed by Social Security ($160,200 in 2023 ) in any given year, payroll deduction does not affect your Social Security tax or benefits, but it does save you the 1.45% Medicare tax.

Some taxpayers have no change, or a very small change, in Social Security benefits when changing their Social Security tax; situations when this happens are listed here.

Health insurance
If your employer offers health insurance with a substantial subsidy such that the cost of the payroll deduction is less than that of a similar plan on the open market, you should take the health insurance. Even if health insurance isn't subsidized, almost all taxpayers will realize a tax savings by paying health insurance premiums with payroll deduction, due to the way the deduction is calculated.

If the employer-sponsored health insurance is poor quality and/or overpriced, it could make sense to purchase a separate plan.

Health Savings Account
Taxpayers who are eligible to contribute to a HSA have the option of contributing through an employer (if the employer offers this deduction) or directly to a HSA custodian. Usually, the difference is that the contribution is FICA tax-deductible when made through an employer, but not when made directly (although still income tax-deductible, on IRS Form 1040 Schedule 1 line 13). If the employee's total wages for the year are less than the Social Security Wage Base ($160,200 in 2023), this tax deduction likely causes a reduction in future Social Security benefits. Per an analysis of benefits, low-earners should not avoid FICA tax, middle earners will roughly break even, and high earners should avoid FICA tax where possible. Taxpayers earning more than the Social Security Wage Base will only save the 1.45% Medicare tax and possibly the 0.9% Additional Medicare tax, but face no reduction in future benefits.

As mentioned above, in some cases there can be tax impacts from this decision aside from just FICA taxes, which should be factored in as well.

Some employers offer a match on HSA contributions made through payroll deduction, and this match likely outweighs any tax or Social Security benefit differences.

Child and dependent care
Child and dependent care expense deductions are typically available through a Dependent Care Flexible Spending Arrangement (DCFSA), a type of limited-purpose FSA. Expenses paid by an employer (including through a DCFSA) are not eligible for the Dependent Care Credit, reported on IRS Form 2441; see also IRS Publication 503. The tax credit rate varies between 20% and 35% depending on AGI, but notably cannot phase out to less than 20% regardless of income. You should compare the tax savings from the FSA (which is at your marginal tax rate) to the credit rate and choose the option with the higher rate, also considering any differences in Social Security benefit. A DCFSA is a use-it-or-lose-it account, so the risk of unused savings should also be considered.

It is possible to both deduct dependent care expenses through payroll and also take the Dependent Care Credit, but the expense limit for the credit ($3,000 of expense for one dependent, $6,000 for two or more dependents) must be reduced by the amount deducted. For example, if a taxpayer has $15,000 of daycare expenses for two children and contributes $5,000 to their employer's DCFSA, they are eligible for the dependent care credit on only $1,000 (= $6,000 - $5,000) of qualifying expenses.

Note: For tax year 2021 only, the American Rescue Plan Act of 2021 expanded the Child and Dependent Care Credit to up to $8,000 of qualifying expenses for one dependent and up to $16,000 for two or more dependents. The credit rate also increased to up to 50% of qualifying expenses depending on income, although the credit phases all the way down to 0% for taxpayers with an AGI above $438,000. This one-year change is set to revert for tax year 2022 and beyond.

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 $200,000 for 2022, $215,000 for 2023
 * 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.