An important aspect of an employee’s paycheck is that it is usually heavily taxed before the pay reaches his account. However, there exists a wonderful though little-used tool that is capable of legally shielding a portion of a person’s income-from federal taxes, and in most instances, from state taxes. Understanding the array of section 125 plan benefits can be the key to keeping more of your money and using it for the things you truly need. This affects your income directly-in how you take care of sec 125 taxes, it takes the control back into your hands on how you want to shape your financial wellbeing.
How Can You Do That Legally?
As simple as that. A Section 125 Plan, more popularly known as a Cafeteria Plan, allows you to pay certain qualified expenses with pre-tax dollars. Because it would lower your gross income on paper, you would automatically lower your overall tax liability.
Let’s say you earn $50,000 a year. You put $3,000 into a Section 125 Plan to be spent on medical expenses. The government now sees an income of $47,000 for tax purposes as you have not been taxed on that $3,000. So, you are not taxed on that part; in fact, you save the fraction you would have spent in tax on that amount. It’s not a deduction you claim when you file taxes at the end of the tax year; it is exclusion at the front end, so it adds to the disposable income all year.
What Expenses Are Covered with Pre-Tax Dollars?
This is one area of their flexibility and attraction. Rather than being a blanket solution, the plan may really be a menu of options that you can personalize for your specific life situation. Two of the best-known are:
Medical Expense Accounts:
Better known as Flexible Spending Accounts (FSAs), you can set aside from $200-$5,000 annually in your account for costs not reimbursed by your primary insurance. Such a range of items and services can and usually would include anything from co-pays for doctor visits to prescription medications, eyeballs and dental work, and even certain over-the-counter items with a doctor’s prescription.
Dependent Care Assistance:
Particularly appealing for an employee with children or other dependents, this allows you to apply pre-tax dollars to costs associated with eligible daycare, preschool, and after-school care programs. The dependent adult who resides with you and for whom you claim an exemption can also qualify. Estimate the annual savings you get from this cost-cutting method, and you will painfully appreciate the fraction of costs that one may save in expensive dependent care.
Are There Any Rules You Should Be Aware Of?
The biggest thing to remember is that these work on use-it-or-lose-it principles, and that’s the really primary rule. Normal contributions you elect to make are to be consumed within that plan year, although a small grace period extension may be allowed by some employers or limited carryover into the next year. All this means careful planning, of course.
Each time you conduct your employer’s open enrollment, you must make the most accurate estimation possible regarding next year’s eligible expenses. Get it wrong by overestimating and the taxpayer loses the leftover amount. Underestimating means missed potential tax savings. This requires a thoughtful review of your anticipated needs for the coming year.
What is the Overall Financial Picture?
Its cumulative effect not just bounces your paycheck a little higher but transfers dollars more commonplace on a regular, ongoing basis to pre-tax use for spending you would have incurred anyway. Other goals that the savings might be redirected to include creating an emergency fund, contributing to a retirement account, or saving toward that major purchase.
In addition, because these deductions reduce one’s adjusted gross income (AGI), they can be positively rippling into other areas financially. Under sometimes lower AGIs, one may qualify for other tax credits or deductions that phase out at higher income levels, creating yet another indirect benefit.
Is This Opportunity Right for Your Situation?
Ultimately, it is a personal and financial decision as to whether someone should enroll. For predictable medical expenses such as ongoing prescriptions or planned dental work, a medical FSA is a great option. The dependent care account will likely prove a financially wise decision almost every time for families with steady childcare expenses.
The key is to do proactive financial planning. And during your next benefits enrollment period, take some time and think through the various options carefully. You may want to calculate how much tax you will save, how much you will spend on out-of-pocket expenses in the coming year, and check whether putting part of your salary aside as pre-tax salary allocation fits your financial roadmap. A minute, administrative step in exchange for a big, easy, and worthwhile dividend.
