Flexible Spending Accounts (a.k.a. Section 125 Plans) provide an IRS-approved way to lower taxes for both employers and employees. These plans allow employees to redirect compensation to pay for qualified unreimbursed medical expenses, dependent care expenses, certain insurance premium contributions, and adoption expenses before personal taxes are computed on their paychecks. Employees end up paying less taxes because their taxable income is lower.
Employees also don't have to pay Social Security tax on amounts placed in their cafeteria plan accounts. This means the business saves taxes as well, because it pays less in Social Security matching funds.
While sole proprietors, partners, members of an LLC or LLP (in most cases), and individuals owning more than 2% of an S corporation may not participate in a cafeteria plan, they may still sponsor a plan and benefit from the savings on payroll taxes attributable to other employees.
Unreimbursed Medical Expenses
Unreimbursed medical expenses are those which are not covered by an insurance plan. Under current law, only expenses that exceed a deduction floor of 10% of AGI are deductible.
With a flexible spending account, certain medical expenses become, essentially, tax deductible. Covered expenses include insurance deductibles and co-pays, doctor's office visits, dental and orthodontia expenses, vision care, eye surgery, prescription drugs, and medical transportation costs.
Dependent Care Expenses
Many cafeteria plans allow employees to pay for up to $5,000 of child and adult dependent care expenses each year with pre-tax dollars. Generally, a child or dependent must be younger than 13 or disabled for expenses to qualify.
Dependent care expenses paid through a cafeteria plan will reduce the amount of the taxpayer's Child and Dependent Care Tax Credit on a dollar-for-dollar basis.
Set up a flexible spending account to allow employees to pay for their dependent care expenses. This will likely save them more tax dollars than they would save with the child care tax credit.
Health Insurance Premiums
Many employees must pay for a portion of their employer-sponsored health insurance premiums. By allowing employees to deduct their premiums from their pay on a pre-tax basis, the employer can save on taxes. In fact, for every dollar employees spend on health insurance, the employer saves 7.65%, or the FICA match.
Premium Only Plans are simple to set up and easy to administer, and unlike other types of flexible spending accounts, they do not require filing claims or an IRS tax filing.
Employees adopting a child can be reimbursed through a flexible spending account for up to $14,080 in 2019.
Employees can only take the reimbursement once per child. If the adoption process spans several years, employees need to consider which year will be best for this reimbursement.
Your employees may benefit by using the adoption assistance as a tax credit. The $14,080 limit is the same as if the reimbursement is filed through a flexible spending account. If the eligible expenses exceed the limit, both the flexible spending account and the tax credit may be utilized. If employees are in the 25% tax bracket or higher, paying for adoption expenses through the flexible spending account may save them more than the credit. The tax credit gradually phases out based on adjusted gross income.