The possibility of a costless benefit plan comes from a single concept. In every financial transaction there are at least three parties: the payer, the payee and the government. When you pay your employees, both you and they pay taxes. Through payroll withholding or otherwise, employees must remit income taxes to a variety of governmental agencies. They also pay to fund both the Social Security (FICA) and Medicare systems. You, then, match the amount which they pay to the Social Security Administration and Medicare. Cafeteria plans provide a means to partially exclude the government from a part of the payroll transaction.

What is a cafeteria plan? Cafeteria plans are defined under Section 125 of the Internal Revenue Code as a plan that allows an employee to choose where his or her benefit dollars will be spent. The plan can provide a number of selections, including medical, accident, disability, vision, dental and group term life insurance. It can reimburse actual medical expenses. It can pay children’s day care expenses. And, it does these things with pre-tax dollars. One thing to remember is that these benefits must be funded with tomorrow’s earnings, not yesterday’s. By that we mean, each person must estimate the costs that he or she will incur during the plan’s upcoming year and request to have the estimated amount redirected from wages into the plan.

The most common type of cafeteria plan provides a basic core of benefits including minimal levels of medical and life insurance, sick leave or disability benefits, plus a second layer of optional benefits. At a minimum, the basic benefits should provide a reasonable level of protection against the major sources of personal risks. The employee can select the core benefit, or alternatively, purchase a higher level of benefits with cafeteria dollars. The plan might also add benefits that were not previously offered as options.