May cash be taken out of the options under a 125 plan?

[JJD]

I have a client that has a 125 plan providing for purchase of benefits through employer provided credits and pre-tax salary reduction by employees.

The client wants to increase employer provided credits under the plan but to default unused credits into elections under a 401(k) plan or health care reimbursement plan. The effect, in other words, would be to take cash out of the choices.

Is there anything that would prevent this (considering the matter primarily from the 125 angle)?

If the matter were just one of an employee's making choices among employer provided, nontaxable benefits, I don't know that there would be. My main concern, I guess, is whether pre-tax contributions by employees would be permitted to such a plan.

May cash be taken out of the options under a 125 plan? Would such a plan, though not a 125 plan, be permissible? Anyone have any thoughts?

Thank you, John.

[papogi]

Once the employer removes the cash option, there are no constructive receipt issues to bypass, so Section 125 is not required to protect the employees from the value of the employer-provided coverages. Basically, they have created a plan which only needs Section 105 (amounts received from the plan) and 106 (employer contributions to the plan) protection. If these employer-provided credits are not enough to cover the costs of the desired coverages, the employee can still pay his/her portion as an elective salary reduction under Section 125, as long as the 125 plan is in place. The only thing that is changing here is that the employer-provided credits are no longer required to be funneled through the 125 plan. The employees with elective salary reductions are the only ones participating in the Cafeteria Plan in this case.

I admit I don't remember ever seeing this exact situation before, so someone else please chime in if you have more insight.

[Kirk Maldonado]

Are you certain that the "rollover" of the surplus funds into the Section 401(k) plan won't be treated as a "cash equivalent" for purposes of the cafeteria plan rules?

[papogi]

I don't see that it would help. In fact, 401(k)(2)(a) states that "a covered employee may elect to have the employer make payments as contributions to a trust under the plan on behalf of the employee, or to the employee directly in cash." The optional "cash" under 401(k) must actually be cash, and cannot be a taxable benefit (unlike 125, which treats taxable benefits as cash). I am not well versed on matters concerning 401(k), but I'm wondering if this plan design will not be kosher under 401(k). Perhaps it would be OK because we are talking about employer amounts, not true elective deferrals. Either way, I don't think it helps bring this plan into 125 compliance as far as the employer-paid portions are concerned.

[Kirk Maldonado]

My first post assumed that, at the end of the year, any funds remaining in the health FSA would be rolled over into the Section 401(k) plan.

I think that arrangement is impermissible, because it thwarts people from incurring forfeitures. Thus, I believe it would be treated as a cash refund of amounts remaining in the FSA account at the end of the year, violating the "use it or lose it" rule.

[papogi]

I don't think that's specifically what JJD was saying (he was looking at unused credits having to go to an FSA or a 401(k), not one then the other), but I do follow your reasoning and agree completely. The clarification is good.

[JJD]

Thank you for your responses.

I agree that unused medical reimb. account monies could not be rolled over into a 401(k). The client's idea is for employer monies to default to a 401(k) or medical fsa to the extent not allocated at the time of enrollment (rather than at the end of the plan year).

In reconsidering the situation, I am wondering whether the employee's own option to reduce salary would not by itself constitute a choice between nontaxable benefits and cash that would enable a plan providing for salary reduction to count as a cafeteria plan even if all employer provided credits under the plan had to be used for nontaxable benefits?

Any thoughts?

[papogi]

An employee's option to salary reduce only puts the affected benefits under 125. As an extreme example, assume an employee gets the company's credits and decides to opt-out of the plan entirely. Under your client's proposal, the entire credit balance must be applied to 401(k) and/or an FSA. There is no cash option. This plan is not operating under 125, since there are no constructive receipt problems. In another example, an employee uses all of his/her credits buying coverage, and must fork over some of his/her own funds. My thinking is that these employee amounts can be put through a 125 plan to be pre-tax since there is a cash option. This doesn't erase the fact that the employer-paid portion has no cash option, so this portion cannot be going through the 125 plan.

[JJD]

Thanks for your response.

What you say reflects how I was also initially thinking about it--if there's no option to convert employer credits into cash, then there's no cash option.

But I'm wondering whether an employee's decision to forego salary reduction is not itself a choice between cash and benefits. In effect, an employee foregoing salary reduction would have elected cash instead of benefits.

Along that line, suppose, for example, that a cafeteria plan provided only for employee reduction of salary as the means for funding fsas, medical insurance, and other benefits.

Wouldn't this still be a cafeteria plan?

[papogi]

An employee's decision to forego salary reduction (effectively electing cash instead of benefits) is indeed an election related to a 125 plan, although it is an election that means that the employee is not even participating in the 125 plan. If you're trying to say that since employees can possibly use all their credits and have to go into pre-tax payroll deductions that this makes all the benefits in their entirety operate under the 125 plan, I disagree. It comes back to the employer credits used first. They simply are not operating under 125 if there is no cash option for that portion. 125 begins where benefits with no cash option end. I think that what the employer is proposing is legal, it's just that a large part of it will not be under 125 (with no cash option, these funds would not be used in the 25% Concentration Test, for example). I'm not saying that this employer doesn't have a 125 plan, they do. I'm just saying that those employees who do not have any pre-tax payroll deductions are not participating in the 125 plan. Since they, specifically, had no cash option on the benefits they elected, they are not in the 125 plan.

In your second example, an employer that only uses pre-tax payroll deductions to fund benefits is operating under a 125 plan, as well. It has nothing to do with the fact that the benefits are funded entirely by the employees, it has to do with the fact that employees have a choice between salary and benefits.