How Employee Benefits Can Impact Employer and Employee Taxes

How Employee Benefits Can Impact Employer and Employee Taxes
If you are like many small businesses thrown for a loop during the pandemic, you may not be prepared for this year’s tax season. Your company can optimize revenue and provide an excellent benefits package while minimizing your tax liability if you know what opportunities are available. Here are some strategies related to employee benefits to help your small business during tax season:

Tax-Favored Savings & Spending Accounts

There are several different types of savings and spending accounts available in the employee benefits space (FSA’s, HSA’s, DCFSA’s, etc.), all of which can help lower taxable income at the employee level and lower payroll taxes for companies.  Most cannot coexist at the employee level, so you want to be sure what is offered is both understood and implemented correctly.  At the highest level, most of these types of accounts (except the Dependent Care FSA, which we’ll discuss shortly later) provide employees and employers a way to pay for healthcare-related costs with untaxed dollars. IRS Publication 502 goes into detail on what CAN be paid using any of these types of accounts.

A word of caution, not all spending and savings accounts play well together, and some cannot coexist side by side. For example, you cannot actively contribute to a Health Savings Account (HSA) and a Healthcare Flexible Spending Account (HC FSA) at the same time.  If you were on an HSA, you could implement what’s known as a Limited Purpose FSA which can be used only for dental and vision expenses. Many have different features as far as how long funds can / will remain in the account.

Health Savings Accounts are geared more toward long-term savings and typically managed by a bank or credit union. These are set up to be long-term, and funds in these types of accounts belong to the employee and will always remain there until spent, whether that’s six months from now or six years from now. Most Health Savings Accounts also have an investment feature where you can start investing those funds, and earnings are untaxed. Many people refer to HSA’s like a 401k for healthcare.

On the other side of the fence, the various spending accounts all have a use it or lose it type provision, so you need to plan carefully when depositing funds to make sure you are not overfunding, resulting in a loss.The spending accounts are similar to a savings account, but the money is earmarked for healthcare expenses. The cost is paid for with pre-tax dollars collected by an employer through pre-tax payroll deduction (if the company has a Section 125 plan setup). When a Section 125 Plan is in place, the employee and employer both benefit immediately as the insurance costs are deducted on that check, lowering the employee’s taxable income and the employer’s payroll tax liability. This isn’t a tax benefit that you have to wait and get when you file your taxes later.

There are annual funding limits set forth for all of these different types of accounts, and most tend to get updated by the IRS every year or two. For employees who are looking to lower their taxable income, pay for healthcare-related expenses with untaxed dollars, or who would like to start a long-term savings account for future healthcare use, one of these types of accounts might make sense for a company to implement.

Employers can help with the funding if they choose to, or 100% of the funding can come from the employee in a payroll deduction. The maximums still apply, regardless of who is funding the account. Every employer/employee situation is different, but the nice thing is that you have options, and these can be customized to fit the need of the employer and employee alike.

Here are the different types of saving and spending accounts available:

  • Health Saving Account (HSA): This is a type of savings account that allows funds to pay for qualified medical expenses and reduces taxable income. Managed by a financial institution, most have investment options, and there’s no use it or lose it feature.
  • Flexible Spending Account (FSA) FSA’s funds are not available long term, as these types of accounts have use it or lose it provisions. Some can be set up with a small rollover or an extended claim filing timeframe at the sponsoring employer’s discretion. Still, you do want to be careful and make sure employees understand how the plan operations. There are a few types of actual FSA’s well discuss briefly:
    • Healthcare Flexible Spending Account (HCFSA): Money in an FSA can be used for specific health, vision, and dental expenses not covered by a health insurance plan.
    • Dependent Care Flexible Spending Account (DCFSA): This account can be used for eligible dependent care services, such as camps, preschool, daycare, and more. This type of account is a great benefit for working parents.
    • Limited Purpose FSA – A limited purpose FSA allows those who have an active HSA funded by another avenue to pay for eligible dental and vision expenses through an FSA. While not as common, these can be great tools for maximizing their tax savings potential that has known costs for dental or vision over the year.

All these benefits are primarily tax-driven because, according to the IRS, they can be funded with pre-tax dollars employers or payroll vendors can collect through payroll deduction. When expenses are incurred later and paid out of one of these types of accounts, the related expense gets paid but the money moving from the spending / savings account is not a taxable event to the employee.

Employee Sponsored Life Insurance

In general, most employers can provide up to $50,000 of life insurance that goes untaxed. If the life insurance amount exceeds $50,000, then the IRS calculated cost of the additional coverage is subject to federal taxation. Many small businesses are not aware of this, but most payroll companies, financial planners, or CPAs can help. Working with a professional ensures your organization is capitalizing on every advantage available.

Section 125

Section 125 is part of the IRS tax code allowing employers to create a tax savings arrangement, often referred to as a Cafeteria Plan. Section 125 plans enable employees to convert a taxable benefit, like their salary, into a benefit deducted on a pre-tax basis.

This is a common plan to have for most employers, as it lowers taxes for all involved.

Qualified benefits include (with some exceptions) accident and health benefits, adoption assistance, dependent care assistance, group-term life insurance coverage, and even FSAs and HSAs, which we previously discussed.

It is essential to set up a Section 125 document for your company so these benefits can be deducted pre-tax through payroll. Employers who do not set this up correctly are risking penalties, back taxes, and potential refiling of all employee’s prior year’s W-2 forms. This means more time and money allocated to taxes instead of running your small business. Our team at HBC can set these up for you, assure compliance, and help manage these programs.

How Holloway Benefit Concepts Can Help

As benefit strategists, H|BC provides customized insurance solutions for small businesses. If you are interested in any of the above solutions or curious about how we can help you enhance what you already offer to your employees, we are more than happy to help. Contact us today for more information.

* Note that some business owners and stakeholders in the company cannot get tax benefits through payroll deduction since they are already receiving insurance costs as a business expense.

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