Does your employer offer a group health plan? If so, you’re likely allowed to pay your premiums with pretax money, which comes with tax savings.
To be able to provide pretax health coverage, your employer must establish a cafeteria plan, which may cover medical, dental and vision insurance. (Note that cafeteria plans are also called “Section 125 plans” because they must satisfy the requirements of Section 125 of the Internal Revenue Code.)
Cafeteria health plans offer tax savings not just to employees but also employers. Here’s a breakdown of the different taxes impacting these plans.
Federal Income Tax
Your employer must withhold federal income tax from your wages, unless you meet the IRS’ qualifications for exempt—in which case, no federal income tax should come out of your wages.
If you have a cafeteria health plan, your premiums are deducted from your gross pay before federal income tax is withheld. This process lowers your taxable wages and increases your take-home pay.
Social Security and Medicare Taxes
Cafeteria health plans are excluded from Social Security and Medicare taxes. This means your employer subtracts your premiums from your gross pay prior to withholding Social Security and Medicare taxes—again lowering your taxable wages and increasing your take-home pay.
Since employers must pay their own portion of Social Security and Medicare taxes, which are based on a percentage of each employee’s wages, the cafeteria plan premiums that are deducted from your wages also result in tax savings for your employer.
State Income Tax
States often follow federal law by excluding cafeteria plan benefits from state income tax. However, not all states do this. For instance, cafeteria health plan benefits are taxable in New Jersey and are therefore subject to New Jersey income tax.
Note that some states impose other taxes on employees besides states income tax. Therefore, you’ll need to check with your payroll department to see if your health benefits are subject to other state-related taxes.
Health Savings Accounts
A health flexible spending account established through your employer lets you pay for specific medical expenses with pretax dollars via salary or wage reduction. Specifically, you pay for out-of-pocket expenses that your insurance doesn’t cover, such as co-pays, prescriptions and annual deductibles, with a portion of your salary or wages that has been placed into a tax-free savings account. This process reduces your taxable income and increases your take-home pay.
Tax Return Deduction
If you pay for healthcare outside of your employer’s cafeteria plan, you may be able to deduct up to a certain amount of those expenses on your federal tax return. For tax years 2017 and 2018, you can deduct qualified medical expenses that exceed 7.5 percent of your annual adjusted gross income. After 2018, the amount goes up to 10 percent. You cannot take this deduction if you have health insurance through your employer’s cafeteria plan because you already received tax savings when your premiums were deducted from your paychecks.