Your paycheck is probably one of the first things that distinguishes gross pay from net pay. The difference generally gives way for taxes, but a good percentage of net pay might actually be taken by benefits such as health insurance. What if there was a way you could actually pre-tax some qualifying expenses so they would directly reduce your taxable income? That is basically how plans with respect to some portion of the Internal Revenue Code work, and many employees wonder what all the sec 125 taxes are about. Learning about these plans is, therefore, the key for making prudent financial decisions each year-round.

What is a Section 125 Plan?

Many of these employees are enrolled in benefit plans and hardly know the formal name of the plans. So, what, then, is this an arrangement that your employer has offered to you?

This means a cafeteria plan under Section 125, in which employers establish some benefit program regarding the employees to make deductions from their salaries for the selected expenses before paying taxes for qualified expenses. In a cafeteria setting, employees can choose their benefits as most fit their needs-with pretax funds “paying” for them. This makes the most sense when it comes to the pre-tax status that reduces AGI directly. The lower your AGI, the less federal income tax you owe if and often state income tax and FICA taxes are applied. Such a way is authorized to keep more of your earnings.

How This Arrangement Lowers Your Taxable Income

It seems very complicated, but the general idea is pretty simple. How does this change things if you adjust the way you pay for something?

Suppose your total annual salary is $50,000. There will be federal income tax on that entire $50,000 if there are no pre-tax deductions. What would happen, other than the federal government now taxing you on $47,000 instead of the whole $50,000, if you withhold from your taxable income $3,000 a year into a medical flexible spending account by your employer’s plan? This amount of pre-tax dollars never shows up as part of your taxable wages, thus instantly lowering your income tax liability. The same idea applies when the premiums for the customer part of employer-sponsored health insurance are paid with pretax dollars. Savings take place with every paycheck, and as such, it provides a regular financial benefit.

The Most Common Types of Accounts Under This Plan

Employers may offer different “lines” into the benefits cafeteria. What are some of the best options available?

The most common accounts are the Health Flexible Spending Account (FSA) and Dependent Care FSA. Health FSAs are used for out-of-pocket medical, dental, and vision costs not covered by your insurance-for example, copayments, deductibles, and special medical supplies. On the other hand, a Dependent Care FSA is intended for qualifying expenses incurred for the care of children (or other qualifying adult dependents) so you (and, if applicable, your spouse) may work or seek work. Adoption assistance or group-term life insurance premiums may be offered by some employers along with the others, subject to the same pre-tax umbrella.

Are There Any Important Rules or Possible Disadvantages?

While the benefits are good regarding tax benefits, there are several specific rules relating to these plans. What things should he or she consider before participation?.

Of these is the paramount “use-it-or-lose-it” rule, particularly for FSAs. Generally, any amount you contribute to a Health FSA or Dependent Care FSA must be used for qualifying expenses incurred for that plan year. After the claims period ends, any unused funds are generally lost. However, employers generally have one of two leniencies that may apply: carrying over a limited amount of funds into next year or providing a grace period of a few months to spend remaining funds. Therefore, planning is very necessary to avoid loss of funds. In addition, participation is generally voluntary, and your election is typically locked for the entire plan year unless you experience a qualified life event such as marriage or birth.

How Can You Benefit Most from This Employee Benefit?

Under the rules, with the benefits, how can you use it strategically?

Careful planning is essential for success. Next, examine your personal estimated medical and dependent care expenses for the upcoming year. Look over last year’s spending as a baseline for spending this coming year. Include predictable expenses-like co-pays for regular prescriptions, planned dental work, and your annual eye exam and new glasses, for example. Consider for dependent care how regular weekly or monthly costs of daycare or an after-school program will be incurred. By estimating carefully and wisely, you ultimately can maximize savings with no risk of having to forfeit any unused funds. Overall, it makes a valuable benefit into a very powerful tool for managing your family’s financial health.