As rising health care costs and inflation place pressure on both corporate and personal budgets, employers and workers alike are looking for ways to save money without sacrificing quality employee benefits. A Premium Only Plan is an option that may offer significant tax savings for all involved parties.
What is a Premium Only Plan?
A Premium Only Plan (POP) is a cafeteria plan allowed under Section 125 of the Internal Revenue Code. With a POP plan, employees can use their pre-tax compensation to buy a group insurance plan or other qualifying benefit.
Section 125 IRS Rules
The Internal Revenue Service (IRS) says a cafeteria plan must meet the specific requirements and regulations of Section 125. These requirements include offering participants the ability to choose from at least one qualified benefit and one taxable benefit. Taxable benefits usually take the form of cash but could include options such as paid time off or severance pay.
A qualified benefit is one that does not defer compensation and is part of the employee’s gross income. Examples of qualified benefits include group health insurance, adoption assistance, voluntary group insurance such as dental or vision, dependent care assistance, group term life insurance or Health Savings Accounts (HSAs). Some benefits offered by employers may not count as qualified benefits under these regulations, such as Archer Medical Savings Accounts and long-term care insurance.
Employers can offer benefits under a cafeteria plan to their employees, along with their workers’ spouses and dependents. Employers can also offer cafeteria plans to former employees, but the plan must not be primarily for former employees.
Employees typically pay for their cafeteria plan insurance premiums using salary reduction agreements. This allows employees to pay using pre-tax dollars. The salary reduction amount is not generally subject to Federal Unemployment Tax Act (FUTA) taxes or Federal Insurance Contributions Act (FICA) taxes.
Payroll Taxes and POP Benefits
The IRS says qualified benefits under a cafeteria plan are not usually subject to FICA, FUTA, Medicare tax or income tax withholding. One notable exception is when a group term life insurance policy provides coverage in excess of $50,000. This benefit is still exempt from FUTA tax and income tax withholding but is subject to Social Security and Medicare taxes. Another exception is adoption assistance benefits, which are exempt from income tax withholding but are subject to Social Security, Medicare and FUTA taxes.
The tax savings only occur if the employee chooses the qualified benefit option. If an employee chooses to receive the taxable benefit (most often, cash) instead of a qualified benefit, the cash amount is treated as regular income and is subject to all applicable taxes.
Potential Tax Savings with POP Benefits
Taxes take a big cut out of business revenue and employee earnings. A Premium Only Plan is a legal way to enjoy tax savings by paying for insurance premiums on a pre-tax basis.
This results in a lower tax burden for both the employee and the employer. Since employees’ taxable income decreases, their income taxes also decrease. Likewise, since employers’ taxable payroll decreases, the federal payroll taxes they owe also decrease.
How much can employers save?
According to the U.S. Bureau of Labor Statistics (BLS), compensation for civil workers averaged $43.26 per hour in June 2023. Only $29.86 of this comes in the form of wages and salary – the rest takes the form of various required and optional benefits. Social Security and Medicare taxes alone add up to $2.46 per hour. By offering qualified benefits that are not subject to these payroll taxes, employers can reduce their total compensation costs without lowering wages.
The amount businesses can save through a POP plan may be significant. For example, since the FICA tax rate is 7.65 percent, an employee who allocates $100 a month to their cafeteria plan can save the employer $7.65 by avoiding FICA taxes alone. Although this may seem like a small amount, it can quickly add up when many employees are using this option.
How much can employees save?
Employees can also save a significant amount of money by avoiding taxes on qualified benefit payroll deductions.
According to the IRS, the 2023 federal income tax rate ranges from 12 percent for incomes starting at $11,000 to 37 percent for incomes over $578,125. Therefore, employees could save anywhere from 12 percent to 37 percent of the qualified benefit payroll deduction amount just by avoiding federal income tax.
For example, an employee who earns $100,000 would be subject to a 24 percent income tax rate. If this employee has a monthly payroll deduction of $100 for qualified benefits under a POP cafeteria plan, the employee could save $288 a year. Larger payroll deductions can result in even bigger tax savings.
The Benefits of a POP Cafeteria Plan Arrangement
As with any employee benefit option, there are pros and cons to consider before choosing a POP cafeteria plan option.
The tax savings are the main advantage for both employees and employers. A POP cafeteria plan could support a company’s recruitment and retention goals by utilizing the money saved elsewhere, like in employee payroll.
The Bankrate 2023 Job Seekers Survey found that 56 percent of workers plan to look for a new job in the next 12 months, and 30 percent consider their pay to be the most important aspect of their employment.
When workers decide whether to accept a job offer, compensation is a key factor, and this includes wages as well as benefits. A POP plan benefit is a way to offer employee benefits while increasing the take-home compensation a worker receives, which can make a position more appealing.
Another advantage of the POP cafeteria plan arrangement is it allows employees to customize their benefits to their individual needs. As employers try to meet the needs of an increasingly diverse workforce, finding a one-size-fits-all solution to employee benefits may seem impossible. However, with a flexible cafeteria plan, employees can select the benefits that best meet their needs and lifestyle.
The Drawbacks of a POP Cafeteria Plan Arrangement
Despite the advantages, employers should consider the potential drawbacks before embracing a POP cafeteria plan.
According to Investopedia, the administration of cafeteria plans can be complex and time-consuming due to their individualized natures. For companies with limited HR resources, this could be an issue, but outsourcing certain HR tasks could reduce this burden.
Another issue with POP plans is that employees have to estimate the amount they are going to contribute in a tax year. This amount is divided by the number of payroll periods and deducted from each paycheck. Complications can occur if the estimate is incorrect, resulting in money forfeited or owed. Investopedia also warns that employers can incur a loss if an employee uses the full benefit but leaves before paying the full annual contribution.
It’s also important to note that tax savings only occur if employees select the qualified benefit option rather than the taxable option (i.e., cash).
Should your organization offer a POP plan?
When deciding if a Premium Only Plan benefit is a good choice for your company, consider both the resources you have available and the needs of your workforce. A POP may be a good option, but it’s also possible that a more traditional total compensation package could be a better match for your company and your workforce.
Regardless of your needs, Higginbotham can help you create and administer a competitive employee benefits plan. Learn more and get in touch with a member of our team to discover the Higginbotham difference.