FLEXIBLE BENEFIT PLANS: A WIN-WIN ARRANGEMENT

By Kenneth R. Lea and
Louis E. Mullen

Would you make your clients or your employer happy by saving them a lot of money? Of course you would. Then tell them about salary reduction arrangements to pay for fringe benefits. Many businesses have already done this, but most employers and their employees still do not enjoy the advantages available from these plans.

Tax Advantages of Flexible Benefit Plans

These salary reduction arrangements are usually called flexible benefit plans (FBP). They allow employees to purchase certain fringe benefits allowed in the IRC with pretax dollars. FBP are similar in some ways to cafeteria plans since both are concerned with employees buying fringe benefits, with them having choices as to which ones to buy. But cafeteria plans provide for the purchase of fringe benefits paid for by the employer; whereas FBP provide for the purchase of fringe benefits paid for by the employees.

Employee payments for FBP are also similar in some ways to their payments into 401(k) and 403(b) accounts. Both reduce the gross income of the employees by the amount deducted from their salaries and wages, with the employee receiving a valuable benefit. They differ in that the benefits received from FBP never increase an employee's gross income; whereas at some future time, when retirement benefits are received from 401(k) or 403(b) plans, the full amount of the benefit received is gross income.

The resulting decreases in taxes are usually quite large. Employees reduce their payroll taxes by 7.65% (6.2% for Social Security and 1.45% for Medicare) of the reduction in pay. In almost all cases they also reduce their Federal income taxes, state income taxes, and local income taxes by their marginal tax rates, less, of course, the value, if any, of the deduction of state and local income taxes on their Federal income tax returns.

Employers receive a tax reduction of payroll taxes equal to that obtained by their employees. Of course, when employees earn more than $68,400 (in 1998), neither the employees nor their employers will obtain a reduction in the 6.2% Social Security tax. Nevertheless, since their marginal income tax rates will usually be higher, the total reduction in taxes obtained by these higher income employees might be as large or larger than those for lower income employees.

FBP Examples

The following examples illustrate the tax savings possible when using FBP for the most common fringe benefits for three levels of gross income; $60,000, $40,000, and $24,000. In all cases, the taxpayers are assumed to be a married couple filing a joint return, both working outside the home and with two dependent children. Child-care costs them $6,000 per year. To simplify matters, the state and local income tax rate, net of the Federal income tax benefit lost, is assumed to be four percent,
two percent, and zero percent of their gross income.

In Exhibit 1 the employees have first $1,000, then $2,000, and then $3,000 deducted from their gross income through the FBP to pay for medical insurance, the most common use of these plans.

Exhibit 2 illustrates the effects of FBP on employers. If the amounts of gross income in Exhibit 1 were representative of the employees of a company, the total yearly tax savings of businesses with 12, 30, and 300 employees would be as shown in Exhibit 2.

The tax savings in the examples above are certainly significant and sizable. And the examples are not extreme or unusual situations; rather they are quite realistic ones. Fairly sizable yearly amounts of salary reduction are likely if the employer offers a plan in which employees use FBP to buy some or all of the following:

1. Medical insurance

2. Dental insurance

3. Liability insurance

And these uses of FBP should cost employers relatively little other than start-up costs.

Other Possible Uses

Other possible uses are medical and dental expense reimbursement accounts and dependent care reimbursement accounts, usually called flexible spending accounts (FSA). When these are used, the employer always reduces its taxes by 7.65% of any amounts of salary reduction. Employees, however, need to compare the advantages and disadvantages of using FBP for these latter purposes.

Employer Costs of Using FBP

For an employer, the disadvantages of having FBP are mainly the start-up and administration costs of the plan. These can be quite large if the employer does all of the work involved. However, few employers attempt to do this, especially those with relatively few employees.

Employers nearly always use an outside firm that specializes in this type of work. It does the initial work of setting up the plan, getting IRS approval of it, and educating the employees on the advantages and disadvantages of the FBP. Then it administers the plan. If only the simple benefits such as medical insurance, dental insurance, and liability insurance are offered to the employees, the cost to the employer should be relatively low, and the employer should realize a net reduction in expenses.

Some large employers might do well by performing these functions in house. They can buy a standard "stock" plan that would nearly always be automatically accepted by the IRS. The cost of doing this would likely be quite large. However, administering the plan should cost very little unless reimbursement accounts are offered. Even for these the administrative cost may turn out to be manageable since, unfortunately, not as many employees are likely to choose these options.

The Advantages and
Disadvantages of Reimbursement Accounts to Employees

For employees, choosing to use FSA is usually a fairly clear-cut decision if the employee understands the advantages and disadvantages of using them. Employees will always obtain tax savings when they choose FBP for medical and dental reimbursement accounts. Since any money not used by year-end is lost, employees usually make conservative estimates of their medical and dental expenses for the next plan year and have this amount deducted from their pay (an equal amount is deducted each payday). The employee then presents receipts for the expenses they pay to the proper persons to obtain reimbursement.

These plans could be especially useful in the following circumstances:

1. The group medical plan does not cover large medical, etc., expenses expected in the next year.

2. The group dental plan does not cover large dental expenses expected in the following year.

3. Group medical and dental insurance is not available through the employer.

But using these accounts for relatively small amounts is probably not sensible.

Using reimbursement accounts for dependent (child) care expenses probably offers net tax savings to more employees. However, employees need to put into these accounts only what they are sure to spend since they lose unused balances at year-end.

And employees need to carefully compare the tax reductions from using FBP and the dependent (child) care credit they could obtain. Using FBP for dependent care expenses is always best when the taxpayer's adjusted gross income exceeds $24,000; the Federal income tax rate (15%) and Social Security
tax rate (7.65%) are more than the dependent care tax credit rate (22%) at that level.

If you assume a combined Federal, state, and local income tax rate of greater than 15%, this $24,000 dividing line goes down. For example, at a 19% income tax rate, the dividing line becomes $16,000 of AGI; the tax savings rate is 26.65%, and the child-care credit rate is 27% for AGI below $16,000.

Reductions in Social Security Benefits When FBP Are Used

When employees use salary reduction arrangements to purchase fringe benefits, they will receive smaller Social Security payments when they retire. This is because Social Security benefits are calculated as a percent of the employee's earned income subject to FICA taxes. The Social Security received by an employee is a very high percent of the lowest layer of earned income and is a very low percent of the highest layer of earned income.

Because of this latter fact, a comparison of the tax savings and the reduction in retirement benefits produces quite different results. Estimated projections in studies indicate that tax savings for low income employees are only one and one-half of the reduction in their retirement benefits whereas high income employees' tax reductions are several times their lost retirement benefits. Of course, when the time value of money is considered, these ratios become much larger.

Thus, nearly all employees greatly benefit whey they use FBP.

However, some employees should not use FBP. A person who has not been employed much or most of his or her adult life needs to have as much income subject to FICA taxes as possible; the lost retirement benefits might exceed any tax savings. And some employees, especially low income ones, probably would be better off not using FBP even if their tax savings do exceed their lost retirement benefits because they will spend, not save, any tax benefits realized, and when they retire their lost retirement benefits will be badly missed. *

Kenneth R. Lea, DBA, CPA, and Louis E. Mullen, PhD, are professors at Tennessee State University.

Editors:
Sheldon M. Geller, Esq.
Geller & Wind, Ltd.

Michael D. Schulman, CPA
Schulman & Company