How Do I Use Pre-Tax Employee Contributions for a Health Insurance Premium?

Written by James Hirby and Fact Checked by The Law Dictionary Staff  

If you own your own business, you'll probably need to offer some form of health insurance coverage to your employees. For starters, such coverage must be provided by all businesses that employ more than 50 full-time workers. The recently-passed Affordable Care Act outlines the terms of this rule. Although these terms are rather complex, two salient points stand out. First, "full-time" employees are defined as those employees who work more than 32 hours per week. Secondly, you don't have to pay for the full cost of the health insurance coverage that you provide. You're more than welcome to compel your employees to shoulder some of the financial burden associated with their health insurance plans.

As an employer, you're expected to offer your health insurance coverage on a tax-free basis. Whether you help your employees set up tax-sheltered "Health Savings Accounts" or simply direct them to a group plan that provides them with cheaper insurance than they could otherwise procure on the open market, you'll need to create a mechanism by which their pre-tax earnings are used to pay for their healthcare costs. This requires informing the IRS of your intention to provide health insurance to your employees. To make this legal, you'll need to fill out the forms necessary to open a "125 Plan."

Also known as "cafeteria plans," these 125 Plans enable you to use a portion of your payroll to fund your employees' health insurance plans on a tax-free basis. When you first set up your plan, the IRS is likely to charge a one-time filing fee of $100 or more. Although you won't be subject to any ongoing reporting requirements, the IRS tends to audit small businesses that use 125 Plans at a fairly high rate. As such, you must save all of your payroll records as well as all of the documents and correspondence related to your group health insurance plan.

Once you've set up your cafeteria plan, you'll be able to deduct your employees' health insurance contributions from their pre-tax pay on an ongoing basis. If you wish to change the terms of your 125 Plan, you'll need to file an amendment with the IRS. Although this is unlikely to require you to pay additional fees, it may increase your chances of being audited during subsequent tax years. If you're required to provide health insurance to your employees, you may wish to seek the advice of a qualified tax professional.

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