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How Do Pre-Tax Benefits Work? An Employer’s Guide To Compliance

by Dave Sanders on Nov 16, 2021 8:31:26 AM

Offering pre-tax benefits to your employees to help them save on their healthcare expenses can make your package more attractive to new and existing employees alike. But how do pre-tax benefits work? There are a lot of administrative requirements you’ll need to meet if you decide to offer a Flexible Spending Account (FSA), Health Savings Account (HSA), Health Reimbursement Arrangement (HRA), or Section 125 Premium Only Plan. And that can be challenging if you don’t have the right staff or expertise in house.

Complete Payroll Solutions has been administering pre-tax benefits for companies for over 18 years to give employees the chance to offset benefit costs with savings from pre-tax dollars. To help you understand the steps involved in maintaining compliance for your pre-tax benefits, here we’ll discuss:

  • How do pre-tax benefits work
  • How do I stay compliant with pre-tax benefits
  • What is the risk of a compliance audit
  • What are the penalties for noncompliance

After reading this article, you’ll know the rules you need to follow to reap the benefits of pre-tax plans and avoid costly penalties. 

How do pre-tax benefits work?

With pre-tax benefits, you withdraw the amount to cover the cost from an employee’s paycheck before it’s taxed. This reduces the amount of taxable wages that an employee has to pay taxes on. The amount of the savings will vary based on the contribution towards the benefit.

There are many different types of pre-tax benefits, but for the purposes of this article, we’ll focus on health plans. These include:

  • FSAs: This pre-tax account, which is owned and set up by employers, is for employees to cover qualified healthcare expenses such as prescription drugs, office visit copays, and dental and vision expenses. Both you and your employees may contribute to their FSA. In addition to tax-free contributions, employees are reimbursed tax-free for their claims.
  • HSAs: HSAs are tax-free savings accounts that can be used to pay for both current and future medical expenses like coinsurance, deductibles, and other qualified expenses. These accounts, which employees own, must be paired with a qualified high-deductible health plan. Like an FSA, both you and your employees can make contributions to the accounts and employee contributions and claim payments are tax-free.
  • HRAs: An HRA is unique from FSAs and HSAs because it’s fully funded by you, the employer. You own the accounts so that also means you can direct how the funds are used and how much is allocated to each employee. Usually, although it’s not required, an HRA is paired with a high-deductible plan, allowing employees to get reimbursed on their deductible expenses. Your contributions are 100% tax-deductible and the reimbursements are 100% tax-free to employees.
  • Section 125 Premium Only Plans: A Section 125 premium only plan (POP) is a tax savings plan that allows employees to pay for their medical insurance premiums on a pre-tax basis. These aren’t insurance plans, so you’ll need to offer a group health plan separately. A POP simply allows your workers to pay for premiums for their group health benefits using pre-tax dollars.

How do I stay compliant with pre-tax benefits?

Like other health insurance plans, there are several steps you’ll be required to take to ensure compliance with applicable rules and regulations, including:

  • Create Plan Documents: You’ll need to create multiple plan documents, including a master plan document and an adoption agreement that explain specific aspects of the plan such as the benefits offered, who is eligible to participate, the manner of contributions, change in status events, and other legal details. Plan documents must be updated and amended at least every 5 years to reflect any applicable plan changes or regulatory updates.
  • Distribute Summary Plan Description: Under ERISA, you’ll also need to furnish a summary plan description (SPD) to all employees participating in the plan that includes essentially the same information as the plan document but in plain language employees can understand. An updated SPD must be provided every year.
  • Perform Nondiscrimination Testing: Pre-tax health plans are generally subject to the nondiscrimination requirements of Internal Revenue Code Section 125. That means, your plan must satisfy the following three tests:
    1. Eligibility Test: This test is used to ensure that the plan doesn’t discriminate in favor of highly compensated individuals in terms of their eligibility to participate.
    2. Benefits and Contributions Test: This test is conducted to make sure that your plan isn’t discriminatory in regard to benefits and contributions.
    3. Key Employee Concentration Test: This test is performed to determine compliance with the requirements that nontaxable benefits provided to key employees do not exceed 25% of the nontaxable benefits provided for all employees.

If a plan fails any of these 3 tests, the highly compensated participant or key employee participating in the plan will lose the favorable tax treatment and must include the greatest value of the taxable benefit they could have elected to receive in their gross income.

  • File Form 5500: Plan sponsors must complete Form 5500 every year electronically through EFAST2. It’s due the last day of the 7th month after the plan year ends so if you have a calendar year plan, the deadline would be July 31. It’s important to note that plans with fewer than 100 participants are exempt from this requirement.

What is the risk of a compliance audit?

There’s no way to predict if your plan will be targeted. However, each year, a number of employee benefit plans are audited by the Department of Labor’s (DOL’s) Employee Benefits Security Administration for compliance.

This could happen for a number of reasons such as a participant or employee complaint about the benefit plan or late or incomplete filing of Form 5500. Other times, an audit may be random since the DOL has the authority to show up at any time.

No matter the reason, during the audit, you can expect the DOL to focus on several things, including your plan documents, amendments, policies, and SPD as well as Form 5500 so be sure to have the current versions ready in advance.

What are the penalties for noncompliance?

Depending on the nature of the violation, the penalties for noncompliance with your pre-tax benefits can range from civil monetary penalties to prison time:

  • Fines of up to $5,000 or imprisonment of up to 1 year for willful violation of ERISA provisions
  • Fines of up to $10,000 and/or imprisonment of up to 5 years for making any false statement or representation of fact, knowing it to be false, or for deliberate non disclosure of any fact required by ERISA
  • A penalty of $110 /day for failure to distribute a Summary of Plan Description or SPD to participants within 30 days of request

Another key consequence that could arise from non-compliance of Section 125 POP requirements is that you could be liable for claims against the plan if the documents don’t give participants accurate information of the plan policies. Also, in a worst-case scenario, the pre-tax deductions may be disallowed from the beginning, leading to an IRS assessment of overdue back taxes plus interest and corresponding penalties.

How to Keep your Pre-Tax Benefits Compliant

Now that we’ve addressed the question, “how do pre-tax benefits work?” you can see there’s a lot to consider when you offer them to keep your plan in compliance. And, since legislative requirements are often changing, it can be time consuming and challenging to keep up with what you need to do. That’s why many companies decide to partner with a third-party administrator (TPA) to make it as easy as possible for you to provide these benefits.

As you’re evaluating providers, you may be wondering if Complete Payroll Solutions could be a good fit for your organization. We’re an ideal TPA if you want:

  • A TPA that serves clients in your industry and businesses of your size
  • Qualified experts who will administer your benefit accurately and compliantly, including guiding you through the laws and regulations and creating required documents
  • One dedicated professional who is knowledgeable about your program and can help you with day-to-day management and issue resolution

To find out what you can expect from our TPA services, read our next article about our pre-tax offerings. If you want to know what things you should look for in a TPA, our checklist of 7 things to consider is a good next read.

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