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Tax Deduction Consulting: S125 Deduction
Section 125 of the Internal Revenue Code permits employers to establish cafeteria plans as a means of providing employee benefits.
A cafeteria plan is a common name for a benefits program that offers an employee a choice among several different forms of benefits. These benefits include life insurance, medical insurance, and child care payments. The idea is that the employee receives a certain amount of compensation in the form of a fund used to "shop" at the benefit cafeteria rather than as wages. This ability to pick and choose exactly what benefits you want is where the name cafeteria originates.
Since the amount of compensation that is given in lieu of wages is actually a form of earned income, it is of interest to the Internal Revenue Service. Section 125 of the IRS code gives the regulations that govern a cafeteria plan and explains the tax implications. At the current time, the IRS allows a $5000 deduction or exclusion from taxable income for a participant in a cafeteria plan under section 125. This is reduced to $2500 for a married couple filing separately.
On the other hand, payments to a fund used for cafeteria plan benefits that exceed $5000 must be reported by the employer as income on form W-2. The cafeteria plan has many good points. The fact that each employee is given a chance to select between options and structure his own benefits package to best cover his own needs is an important factor in their popularity. The ability to exempt the cost of up to $5000 of compensation from taxes is another factor.
In a normal employer benefit program, the individual employee must pay for his benefits with actual taxable income. Although there are always ways to later claim certain portions of this as deductions on your tax return, but many benefits are not deductible or they have limits such as the 7.5% of adjusted gross income starting point for medical deductions.
The qualified benefits paid under a cafeteria plan are gen...