June 26, 2018
Individual benefit programs continue to grow in popularity as employers and carriers search for more creative ways to offer competitive benefits packages. For purposes of this article, when we reference “voluntary benefits” we are referring to those individual polices purchased in the employee’s name but entirely employee-funded through payroll deduction. Examples include cancer, accident, and hospital indemnity policies. The tax treatment of these programs has been a topic of much confusion and misinformation.
As a general matter, current tax rules and new IRS scrutiny surrounding voluntary benefits have led many experts to conclude that post-tax is the better approach for these particular benefit offerings. The following article offers detail explaining why. We hope that our lengthy and substantive article clarifies these issues!
Plans That May be Included in a Section 125 Cafeteria Plan
Although employers (and often employees) prefer to take benefits deductions on a pre-tax basis to reduce the overall gross taxable wage base, not all plans are eligible for pre-tax deductions under the IRS Code Section 125. Only two categories of individual policies may be deducted on a pre-tax basis:
- Accident & Health Coverage (which includes many types of coverage—e.g., supplemental health, specified disease, dental, vision, AD&D, and disability coverage) and
- Individual insurance contracts that qualify as group term life insurance. (Additional tax rules apply; often rules that would direct the employer to impute income to the individual based on how the IRS would measure the value of life insurance coverage. See below for further details.)
Accident & Health Coverage
Treasury Regulations generally defines an accident or health plan as “an arrangement for the payment of amounts to employees in the event of personal injuries or sickness. A plan may cover one or more employees, and there may be different plans for different classes of employees.”
Generally, (unless prohibited by state law) premiums for individual accident and/or health plans may be taken on a pre-tax basis so long as the coverage is excludable from income and is not offered through an Exchange.
A cafeteria plan may offer pre-tax accident or health coverage only to employees, spouses, children who are under age 27 as of the end of the taxable year, and individuals who otherwise qualify as an employee's tax dependents for health coverage purposes. Employers that offer benefits to those who are not qualified for the plans run the risk of disqualifying the plan.
Short-Term and Long-Term Disability Insurance
Both short-term disability (STD) and long-term disability (LTD) plans are eligible for pre-tax deductions under a Section 125 Cafeteria Plan. However, employers and employees should understand the tax consequences of paying these benefits premiums on a pre-tax basis. Essentially, the taxability of the disability benefit payments (i.e. the check the insured receives from money paid by the insurance carrier when out on disability leave) will depend upon how the premiums are paid:
- Pre-tax premiums → taxable benefit payments
- After-tax premiums → benefits payments are not taxable
- Combination pre- and post-tax premiums → benefits are taxable on a pro rata basis using a one-year look-back period (for individual disability policies)
Employers (and employees) should fully understand that tax consequences of taking disability plan premiums on a pre-tax basis prior to including any STD or LTD program in a Section 125 Cafeteria plan. Note that carriers are not always aware when premiums are paid pre-tax. As a result, they may not properly report the benefit payments as taxable. Additionally, because disability payments do not usually fully replace income, most people receiving disability benefits would prefer those benefits not be taxed. For these reasons, many employers find it advantageous to simply require post-tax premium payment.
Group Term Life Insurance
Group Term Life Insurance programs that include individual policies may be deducted on a pre-tax basis under certain circumstances. Specifically, when an employer offers group term life insurance as part of a group of individual contracts provided to a group of employees, these premiums may be taken on a pre-tax basis under a Section 125 Cafeteria Plan. However, in that case, the value of the coverage that is over $50,000 must be included in the employees’ incomes.
Plans that CANNOT be Included in a Section 125 Cafeteria Plan
There are also a number of individual policies that specifically may not be deducted on a pre-tax basis:
- Exchange Plans - Health insurance plans purchased through an exchange (with the exception of SHOP plans) may not be paid for on a pre-tax basis
- Educational Assistance Programs
- Spousal or Dependent Life Insurance
- Archer Medical Savings Accounts (Archer MSAs)
- Health Reimbursement Arrangements (HRAs)
- Long-Term Care Insurance
- Meals and Lodging
- Code §403(b) Benefits in Non-Profits/Educational Institutions
- Individual Health Insurance Policies (whether or not purchased from a state exchange)
Other Excluded Plans and Deferred Compensation
In addition to the specific programs enumerated above, individual policies that defer compensation are not eligible for pre-tax deductions under a Section 125 Cafeteria Plan. Specifically, the current proposed regulations (which govern the rules regarding pre-tax deductions until final regulations are issued) describe deferred compensation this way:
A plan that permits employees to carry over unused elective contributions, after-tax contributions, or plan benefits from one plan year to another…defers compensation. This is the case regardless of how the contributions or benefits are used by the employee in the subsequent plan year…. Similarly, a cafeteria plan also defers compensation if the plan permits employees to use contributions for one plan year to purchase a benefit that will be provided in a subsequent plan year (for example, life, health or disability if these benefits have a savings or investment feature, such as whole life insurance).
Specified illness or fixed indemnity coverage will typically pay a fixed dollar amount if the covered individual is diagnosed with a specific illness (e.g., cancer), is hospitalized, or has another covered medical expense. Under some circumstances an accident or cancer policy may defer compensation and therefor may not be paid for on a pre-tax premium basis. For example, a cancer policy that has a premium reimbursement feature (e.g. premiums refunded in ten years if cancer was never diagnosed) would be considered deferred compensation and therefore specifically precluded from being funded pre-tax.
On the other hand, Cafeteria plan regulations note that the following types of specified disease and fixed indemnity coverages will not result in deferred compensation:
- Coverage for a specified disease or illness, including payments at initial diagnosis of the specified disease or illness, and progressive payments of a set amount per month following the initial diagnosis (sometimes referred to as progressive diagnosis payments); and
- Payment of a fixed amount per day (or other period) of hospitalization.
Taxation of Fixed Indemnity Benefits
In recent months the IRS has clarified that indemnity payments under health policies should be excludable from income up to the amount of unreimbursed medical care expenses incurred. This means that cash proceeds paid to a participant (when premiums were funded pre-tax) are only to be received tax-free up to the amount of the otherwise unreimbursed medical expenses. In other words, if a cancer policy pays a lump sum $50,000 upon diagnosis - the participant would only be entitled to tax-free receipt of that portion of $50,000 to which he could substantiate actual medical expenses. However, substantiating medical expenses can be far easier said than done. For example, upon diagnosis the person may have not yet incurred any substantive medical expenses.
Moreover, carriers peddling these types of fixed indemnity voluntary products lack the ability to validate the underlying medical expenses. As a result, it is usually safer to fund the premiums using after-tax dollars and avoid the possibility of a tax problem.
The IRS also identifies the following specific exceptions to the deferred compensation rules:
- Health FSA Carryovers. Health FSAs may provide for carryovers of up to $500 remaining at the end of a plan year, to be used for qualified medical expenses incurred in subsequent plan years.
- FSA Grace Period. Health FSAs and Dependent Care FSAs may provide for a grace period of up to 2-1/2 months after the end of a plan year, during which participants may access unused amounts to pay or reimburse expenses for certain qualified benefits.
- HSA Contributions.
- PTO Buying and Selling.
- 401(k) Elective Deferrals.
- Certain Contributions for Post-Retirement Group Life Insurance by Covered Employees of Educational Organizations.
Beware of Double Dipping Schemes
Although cafeteria plans allow some benefits to be paid for on a pre-tax basis, not every pre-tax arrangement is legal. As we have written about previously, some schemes, commonly referred to as “double dipping” schemes, basically allow the employee to keep all or most of their income, but have a portion of it not taxed.
Usually, the way double-dipping schemes work is that a “premium” is taken from an employee’s compensation pre-tax. Then, the employee receives a payment equal to the amount of the “premium,” (minus, of course, the promoter’s administrative fee). The payment back to the employee can come in the form of a “reimbursement” or a “wellness payment” or really by any other label. The promoter gets paid, the employee has basically the same income, but pays less tax, and the only loser is the IRS.
These programs are especially dangerous because they can operate “normally” for a considerable period of time before the IRS becomes aware. However, once the IRS learns of the arrangement it will likely require repayment of all under-withheld tax payments, plus substantial penalties and interest dating back to the moment the “double dip” scheme was put in place. In addition to the possibly enormous IRS assessment, impacted employees may have to refile taxes for the years in which their W-2 income understated applicable tax payments. Any employer being offered such an arrangement should be skeptical at the very least.
Plan Document and Other Compliance Considerations
Cafeteria Plan Document
Tax Code Section 125 requires that all plans that take deductions on a pre-tax basis under IRS Section 125 must have a plan document. The plan document includes information such as eligibility, qualifying events, and benefits included in the Cafeteria Plan. Without a plan document, benefit contributions cannot be taken on a pre-tax basis.
Individual Voluntary Benefits ERISA Safe Harbor and Cafeteria Plans
As a general rule, most private employer benefit plans are subject to ERISA rules and regulations. However, in certain circumstances, individual voluntary benefit programs may be eligible for an ERISA Safe Harbor exempting the plans from the ERISA rules. Employers may be able to take advantage of the ERISA Safe Harbor if the all of the following conditions are met:
- The employer does not make any contributions to the cost of the plan – the plan is paid 100% by the employee;
- Employee participation is completely voluntary;
- The employer does not publicize or endorse the program – the employer’s role is limited to collecting enrollment forms, taking deductions, and remitting premiums to the carrier; AND
- The employer or employee organization receives no consideration in the form of cash or otherwise in connection with the program, other than reasonable compensation, excluding any profit, for administrative services actually rendered in connection with payroll deductions or dues checkoffs.
The third condition – no publicizing or endorsement – is a very low threshold. Some courts have found that allowing employees to pay for individual policies on a pre-tax basis destroys the ERISA Safe Harbor because the employer is seen as endorsing the voluntary plan. Generally, loss of the safe harbor does not significantly add to an employer’s administrative burdens. However, if the employer has not treated these benefits as subject to ERISA, the employer could be responsible for penalties for failing to file Forms 5500 or failing to distribute summary plan descriptions. Therefore, employers should fully understand the risk of paying for certain benefits on a pre-tax basis and the possibility of losing the voluntary plan safe harbor. HUB can provide additional education on the safe harbor.
NOTICE OF DISCLAIMER
The information herein is intended to be educational only and is based on information that is generally available. HUB International makes no representation or warranty as to its accuracy and is not obligated to update the information should it change in the future. The information is not intended to be legal or tax advice. Consult your attorney and/or professional advisor as to your organization’s specific circumstances and legal, tax or other requirements.