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Your Cafeteria Plan and Disability Benefits

November 11th, 2010 • 0 Comments • Posted by admin

A Section 125 Cafeteria Plan is a great way for employers to offer benefits that it could not otherwise afford to provide.  Because the benefits are offered on a pre-tax basis, the premiums essentially cost the employee less than they would if s/he were purchasing this benefit on his or her own with after-tax dollars.

One of the benefits that can be offered through a cafeteria plan is disability benefits.  So, if the employee is hurt or becomes ill, and is unable to work, he or she can collect on the plan and have funds available for living expenses.

While this is certainly a useful benefit, paying for a disability policy through a cafeteria plan can reduce the benefits the employee receives.  This is because the employee pays the premiums with pre-tax dollars; that is, the dollars used to pay for that disability insurance policy were never taxed.  So, if benefits are paid, the IRS wants its revenue on the back end, and those disability benefits become taxable to the employee.  This can take an unfortunate chunk out of the benefit payments meant to support you while you recover.

On the other hand, if you were to purchase a disability insurance policy on your own, or if you purchased one through your employer but paid the premium with after-tax dollars, any benefits paid to you are completely tax-free.

So, how does the taxation work?  If the insurer pays the benefits directly to you, it may take withholding, FICA, and Medicare directly out of the payments it makes to you.  The amount of the benefit payments will then be added to your taxable wages on your Form W-2, or you might receive a separate Form W-2 just for the insurance benefits.  If it’s an option to have taxes taken out of the payments as they occur, you should probably do it – you don’t want to have to pay the full amount of the taxes next April 15.  Sometimes the employee gets benefits and doesn’t realize they’re taxable until the W-2 or 1099 arrives the following January…and then, it’s too late.

Of course, the benefits won’t be taxed at 100%, and it’s certainly better to have taxable disability benefits than to have no safety net at all should you become hurt.  You will still have some money coming in.   Still, if you’ve been hurt, you will need all the money you can get.

If the pre-tax premium through a cafeteria plan is the only way you can afford a disability policy, you should have one.  But if at all possible, try to get your disability policy – or an extra disability policy – on your own, outside of the cafeteria plan.

Best of all, just hope you never need it.  But in any case tax advantages aren’t the only consideration, when an employer or employee considers what items they include in their Section 125 plan they should take council from a professional.


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