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Cafeteria plans provide health care savings

Company cafeteria plans are well worth a look if you want to protect your family's health and well-being and save a few tax dollars while you're at it.

Although virtually unheard of 20 years ago, today some 20 percent of U.S. corporations offer cafeteria benefits.

Put simply, cafeteria plans are company benefit programs that allow employees to use pretax dollars to pay certain out-of-pocket expenses. They are not health insurance plans.

Cafeteria plans -- also called 125 plans because they are defined in Section 125 of the Internal Revenue Service Code -- are so-called because employees can pick and choose from a menu of benefits custom designed by the employer. The choices most-often offered are premium conversion and flexible spending arrangements.

Premium conversion
The most common component of a cafeteria plan is known as premium conversion, which permits employees to pay their cost of employer-sponsored health insurance premiums with pretax dollars through payroll deductions. In essence, you would save the same percentage of that sum that you would have had to pay in federal income tax had it not been held aside. This is somewhat diminished by the fact that because it's not considered taxable income, it's also not included in your Social Security earnings and could affect your retirement income.

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Flexible spending arrangements
These widely used plans allow employees to pay for non-reimbursable health and medical expenses and day care costs with pretaxed money.

An FSA allows an employee to set aside a pre-determined amount of money through payroll withholdings to pay for certain out-of-pocket expenses.

The money is deducted from the employee's pay check before the income is taxed, meaning it is exempt from federal, state and local, Social Security and Medicare taxes.

Then, after you've spent money on things like doctor bills and day-care, you can request reimbursement from the administrator of your account and you'll get your money back, tax-free. Again, your savings equals the amount you would have paid in taxes had the money not been deducted pretax. If you're in the 25 percent tax bracket and had $3,000 held out for an FSA, you would save 25 percent of $3,000, or $750.

There are two basic FSA plans you should be familiar with, say the experts:

The health care reimbursement account
Commonly called HCRA or Hecra, these allow deferrals from your gross income before taxes into an account that you can use exclusively to pay for medical expenses not covered by your insurance plan. Although the law does not limit the amount you can designate for salary reduction, most employers do set a limit, for example, $5,000.

Through your account, you can be reimbursed for your own, your spouse's or children's health care expenses. Often these funds are used to pay for expenses not normally covered by your traditional insurance, such as acupuncture, chiropractors, birth control, dental work, orthodontics, vision care, infertility, psychiatric care and even prescribed stop-smoking programs. And the IRS recently OK'd using account funds for over-the-counter medications. HCRAs are popular among employees with children, whose needs are often predictable for things such as braces or glasses.

In fact, many people are using HCRAs to replace traditional insurance plans for certain necessities like vision and dental appointments.

Also gaining in popularity is the use of the plans to pay for more unconventional therapies that regular insurance won't look at, such as alternative medicine.

The dependent care reimbursement account
Also known as DCRA or Decra, it allows up to $5,000 a year tax-free for care for children or other dependents. Reimbursement is simple: Each time you pay your child-care provider, you send the receipt to your employer, who cuts a reimbursement check from your DCRA plan.

With both a HCRA and a DCRA, you reduce your current income taxes each paycheck, much like you do with a 401(k) salary deferral. It's like paying yourself back each time you pay qualifying expenses. If 25 cents is taxed out of each dollar you earn, for example, you only have 75 cents left to pay uncovered medical or child-care expenses.

Use it or lose it
But there's some potentially bad news as well -- news that is the biggest single drawback to flex plans and a deal-killer to many employees offered the tax-cutting plan: If you don't use it, you lose it.

At the beginning of each year, you must estimate the amount you're going to spend on these items to determine how much is withheld from taxes each payday. If you overestimate the amount, you forfeit whatever is left over. In May, the Internal Revenue Service loosened the use-it-or-lose-it constraint by announcing that it will allow spending plan participants to make claims against their accounts for up to two months and 15 days after the end of their benefit year. Any money left in the account after that is lost.

"That's probably the single misconception about flex plans -- that you can withdraw your money at any time, that it will always be there," says Kathleen Stoll, director of policies for Families USA, a nonprofit organization that advises consumers on health-related issues. "It's not a piggy bank. People should be aware that there is a risk involved before they sign up. Flex plans can be confusing to many people. That's probably why so few people are enrolling."

James Meyer, vice president of the Washington, D.C.-based Economic and Social Research Institute, agrees: "The use-it-or-lose-it' flex or cafeteria plan is not proving popular simply for that reason. People do not want to take the chance of losing their hard-earned money."

Studies by benefits specialists regularly show that employees typically forfeit more than $100 each year in flexible medical accounts. Worse yet, the money forfeited usually goes to the employer, something that particularly annoys many employees. Businesses generally use the leftover money to help defray administrative costs of the program. In some instances, employers allow workers to designate a charity to which the unused funds are sent.

A pre-approved benefits 'loan'
The flipside to the use-it-or-lose-it gripe, however, is that you can get to the money even before it's in your account, and if you spend more than you've set aside and leave the company, you don't have to pay it back.

Say you elected to put $2,400 in your medical spending account, with $200 a month coming from each of your 12 paychecks that year. In early March, your son fell off his bike and, in addition to breaking his arm, all his expensive orthodontia had to be redone. When all the damage was added up, you faced $950 in deductibles not covered by your health insurance.

Although you only had $400 in your account when the accident occurred, federal guidelines allow you to submit your out-of-pocket expenses immediately for repayment. This way, you get cash today against the total amount you pledged to pay into the account tomorrow.

Other FSA drawbacks

  • With a DCRA, you must provide the tax ID number or Social Security number of your child-care provider. This presents a problem for anyone paying caregivers under the table and is one reason why so few employees choose to participate in these plans.
  • Also in a DCRA, you're not allowed to use the standard child-care credit on your tax return. This could pose a problem for a lower-income worker, who might be better off sticking with the credit. Most employers provide a worksheet in the initial enrollment kit to help you figure out which option works best for you.
  • With either reimbursement account it's difficult to change your level of participation. Unless there is a major change in your life -- marriage, divorce, birth of a child, reduction in work hours, or job loss or change by your spouse -- you're stuck with putting in what you chose during the enrollment period. Similarly, only a life-change event will get you into a flexible spending account plan if you miss the sign-up deadline. For most companies, the deadline is Dec. 31. But some operate on a fiscal, rather than calendar year, so check with your benefits manager for your deadline.
  • Then there's what many call "the $5,000 joke." The IRS limits the annual contribution for dependent care accounts to $5,000. This is a family limit, meaning that even if both parents have access to flexible care accounts, their combined annual contributions cannot exceed $5,000. Linda Wurzelbacher of BASIC, an employee benefits administration firm, says, "Employees are always telling us $5,000 is a joke," she said. "It's not an amount that has kept up with the times. Anybody with kids will tell you that they easily exceed this amount in day care in a year."

Bill Burt is a freelance writer based in Florida.

-- Updated: May 23, 2005

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