Dear Tax Talk, My employer takes out about $300 a month for health insurance from my gross pay, and I am told that this is before taxes to save me money. However, when I get my W-2 form, all the money I pay for health insurance is included as “wages, tips and compensation,” so it really saves me nothing at tax time.

I have argued this point with them, but they say that they have to include it. I don’t believe this is right, because there is then no real tax saving advantage, as I pay Social Security taxes, as well as Medicare, federal and state taxes on everything, including what I paid in for health insurance. What’s right?
— Dave

Dear Dave,
You must be working for really dumb people. Employers generally establish a health insurance plan to be payroll tax-free. The employee saves some payroll and income taxes, but the employer makes out better by not having to match the payroll taxes. In your case of $3,600 a year, you save FICA and Medicare tax of 7.65 percent and an income tax that can be 10 percent or more if you have a semi well-paying job.

There is a matching 7.65-percent payroll tax savings to your employer as well. While that may only mean $275 for you, when your employer multiplies it by all the employees, it can add up quickly.

In order for the payroll reductions for health insurance to be tax-free, the employer has to establish a cafeteria plan. A cafeteria plan is a benefit plan that offers the employee the option to forgo part of his or her compensation on a tax-free basis in order to provide certain fringe benefits.

Cafeteria plans come in various sizes and shapes and differ from employer to employer. A basic cafeteria plan is called a premium-only plan. The plan only provides for the exclusion from income and payroll taxes the amount of health insurance premium deducted from the employee’s wages. The plan is simple to administer, as it only requires the employer to deduct the premiums from the employee’s paycheck, which is something that they would do whether or not tax-favored.

The plan is tax-free is because part of your pay covers the cost of the insurance. Suppose you make $50,000 annually. If your employer gave you the full $50,000, all of it would be subject to payroll taxes, including income taxes. Now, if the employer establishes a premium-only plan, and says to you I can offer you health insurance for $300 a month, your salary becomes $46,400 plus $3,600 in benefits.

Because health benefits are favored under the law, you avoid paying payroll taxes on that part of your salary reduction. If, instead of health insurance, your employer offered you a car for $300 a month, the $300 continues to be taxable, as a car allowance is not an excludable fringe benefit.

Your employer must establish a plan in order to provide you with the tax-free benefit. Most qualified health insurance agents will provide a plan and administration as part of the sale of the health plan. I hope this makes sense to your employers.

To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Taxpayers should seek professional advice based on their particular circumstances.