Named for the section of the U.S. Tax Code that establishes them, Section 125 plans permit employees to contribute a portion of their pay on a pre-tax basis to Flexible Spending Arrangements established to pay for certain insurance premiums, out-of-pocket medical and dental expenses and dependent care expenses. Individual employers establish Section 125 plans voluntarily as a fringe benefit for their employees. While the expenses paid from FSA contributions technically are not tax-deductible on your annual income tax return, they are exempt from income and social security tax.
Step 1
Find employment with a company or government agency that offers a cafeteria plan or ask your current employer to set one up. Employers benefit by paying considerably less in payroll taxes, and from the goodwill generated by reducing their employees' tax liability.
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Step 2
Read your employer's plan book carefully. Check to see if you are an "eligible" employee. You will probably qualify if you work 50 percent of the time or more.Cafeteria plans are so named because employees may select from among several plans employers may establish, including plans to pay for dependent care expenses, qualified medical and dental expenses, or qualified insurance premiums.
Step 3
Select one or more of the plans to participate in and the amount of your annual contribution to each. This generally requires some planning. For example, if you open a dependent care FSA, your annual contribution, which is made on a pro-rata basis from your regular earnings, should be based on your best projection of what you'll pay out-of-pocket for dependent care for the year. Once you join, usually during an open enrollment period shortly before the beginning of the plan year, you cannot change your contribution or leave the plan until the end of the plan year.
Step 4
Contribute to the plan. Except for health FSAs, which are subject to an annual limit of $2,500 as of 2013, there is no statutory limit on how much you can contribute to the plan; some employers, however, set their own limits.
Step 5
Pay your insurance premiums (under some plans, premiums can be paid directly out of your account), out-of-pocket medical expenses and dependent care costs. Some dependent care FSAs require you to have dependent care providers sign a voucher detailing their services, after which payment is directly deposited to their bank accounts.
Step 6
Withdraw no more than the available balance, which is the sum of all your contributions to date less any withdrawals you've made. You may withdraw funds for qualified medical expenses from your health FSA, though, for any amount up to your annual contribution at any time during the year. For example, if you elect to contribute $2,400 for medical expenses, and you incur a $1,750 deductible at the end of March, you can pay it from your health FSA even though you've only contributed $600 at that point; after that, you'll have an available balance of $650 . However, you must continue to make contributions through the end of the plan year.
Step 7
Complete the appropriate FSA Claim Form. The requirements vary depending on the type of expense being claimed, and may plans provide specialized claim forms for each type of expense. Attach your bills, receipts or other proof of the expenses.
Step 8
Submit the form to your employer. You will be reimbursed for the expenses from your account with pre-tax dollars.
Step 9
Plan carefully to protect against forfeiture. When enacted in 1978, Section 125 originally provided that any unused funds in FSAs would be forfeited back to the employer. Legislation enacted in 2005 and also in the Affordable Care Act softens the forfeiture provisions, and today, employers may select one of two options for dealing with unused funds in an FSA at the end of the plan year. One is to permit employees to use those funds for expenses incurred in the first 2 1/2 months of the next year, and the other is to roll over $500 of unused funds into the following plan year.
Tip
The IRS permits you to opt out of a cafeteria plan only under limited circumstances, usually a major life event like childbirth, adoption, marriage or divorce, or becoming covered under Medicare. In addition, you are automatically disenrolled from a plan if your employment ends.
Warning
Participating in the Section 125 cafeteria plan program will lower your Social Security tax liability, but it also lowers your reportable wages. This is the amount your Social Security benefits will be calculated on when you retire. You could end up receiving less money in your monthly checks.
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