Section 125 of the Internal Revenue Service code gives employers the option to offer employees a plan that allows the employee to pay qualified expenses with pre-tax dollars. Also called cafeteria plans because the employee typically has an array of options to select from, the 125 plan allows an employee to deposit a fixed amount or a percentage of his salary into a special account. The employee can withdraw money from this account to pay the qualified expenses. Such plans have little effect on your tax return.
How Does a 125 Plan Work?
To participate in a 125 plan, you must agree to a salary reduction. This reduction is deposited into your 125 plan account for you to draw upon later to pay qualified expenses. Because you are not receiving this money as part of your salary, the IRS does not consider it wages and therefore it is not subject to withholding taxes, Social Security deductions or Medicare deductions.
Who May Receive Benefits?
The benefits of a 125 plan must be made available to all company employees. At the option of the employer, the benefits may be also be made available to spouses and dependents. This means that money in your 125 plan account can also be used to pay qualified expenses incurred by your spouse and dependents.
What Are Qualified Expenses?
You employer must have the company’s 125 plan carefully written, offering employees both taxable benefits and non-taxable benefits. Generally, employees use a 125 plan for the non-taxable benefits. Samples of non-taxable qualified benefits that may be offered in a 125 plan include the payment of premiums for accident and health insurance, costs for dependent care such as daycare expenses, premiums for group term life insurance and the payment of medical bills.
Affect on Tax Return
Because your contribution to your 125 plan account is made with pre-tax dollars, you will pay less income tax. The W-2 Form you will receive from your employer will take into account the salary reduction that you made. For instance, if your gross salary is $25,000 per year and you contributed $2,000 to your 125 plan, the W-2 will show a taxable income of $23,000. You do not need to file any special IRS forms or schedules to take advantage of this lower tax liability.
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