An employee’s compensation package can include plenty beyond the salary. Fringe benefits, including health insurance, are typically worth a quarter or more of an employee’s pay. Section 125 of the tax code provides generous exemptions for a number of employee fringe benefits, freeing employees from having to pay taxes on the value of common benefits. While the language of Section 125 allows for employers to offer the choice of paying premiums with before or after tax dollars, employers are not required to provide the option.
The main benefit of paying for health insurance premiums on a pre-tax basis, through the use of a salary reduction, is that the employee doesn’t include the premium as part of taxable compensation. Further, by taking a voluntary salary reduction to cover the premiums, the employee doesn’t technically receive any wages, and so the employee doesn’t owe payroll taxes on the premiums, either.
Why Pay After Tax?
People frequently pay large sums to tax planners to find ways to reduce their tax bill. Some people elect to pay more by asking to have health insurance premiums come out after taxes. By avoiding the voluntary salary reduction, which necessitates paying the taxes, an employee can keep her compensation up. Many pension plans, as well as Social Security, set a retiree’s benefits based on his past wages. Taking the premium after tax can cost more in taxes now but increase pay in retirement.
Prior to the beginning of each benefit year, typically during open enrollment time, employees get the opportunity to elect the amounts and types of coverage. If the employer offers the choice between taxable compensation or salary reduction to pay health insurance premiums, the employee must make that choice as part of that election. The worker’s choice is effective for an entire year, unless that worker goes through a midyear qualifying event. Qualifying events include getting married or divorced, having a new child or losing a child, and having a spouse who loses coverage.
Individual Health Insurance
Employers might reimburse employees for going out and finding their own health insurance plans, rather than locking their employees into a group plan. Tax rules permit this type of arrangement to enjoy the same tax preferences as if the employer maintained a group plan so long as certain rules are met. To qualify as a pre-tax benefit, the employer must be able to verify that the employee is using it to maintain an active health insurance policy. Similarly, employees might opt to elect the taxable cash option and use the cash to purchase their own individual policy regardless of their employer's offerings.
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