401(k) Cafeteria Plan
A 401(k) cafeteria plan allows employees who are participating in their employer’s 401(k) plan to also choose additional types of benefits from a smorgasbord of options on a pretax basis.
These benefits can include:
- Group term life insurance
- Flexible savings accounts and health savings accounts
- Disability insurance
- Health or other types of medical insurance such as for critical, chronic or long-term care coverage
- Adoption assistance
- Qualified legal group services
- Stock purchase plans
- Other types of retirement savings accounts such as a 401(k) or profit-sharing plan
- Dependent care assistance
- Other miscellaneous benefits such as cash benefits, commuting and/or parking assistance or gym memberships
Cafeteria plans are organized under Section 125 of the Internal Revenue Code and thus are often called “Section 125 plans” or “flexible benefits plans.”
This flexibility, however, makes these plans more difficult to administer than other types of benefit plans.
Section 125 plans are typically more complex in design than other more straightforward types of employee benefit programs.
In principle, Section 125 plans are designed to prevent any type of deferment of employee income or compensation except through a 401(k) or other type of qualified retirement savings plan.
Who are cafeteria plans for?
Cafeteria plans are well-suited for larger companies that have a diversified workforce made up of single employees, employees with spouses and/or families, older workers and recent graduates.
This type of plan can offer useful benefits to employees of all types who have differing needs and goals.
For example, a young single college graduate may be focused primarily on getting out of debt or saving for retirement, while a married employee with several children is more likely to be interested in medical coverage and medical savings accounts.
Cafeteria plans are offered on a pretax basis, which leverages their value to employees.
Section 125 of the Internal Revenue Code states that the amount of money that an employee contributes to cafeteria plan benefits is not factored into that employee’s gross income calculation.
No Social Security or Medicare taxes are deducted from Section 125 contributions except under certain specific circumstances.
Contributions and Withdrawals
At the beginning of each year, Section 125 plan participants must decide how much money they are going to contribute to their plan for the year.
This amount is then divided equally among pay periods and deducted from the employer’s pay.
Any amount that the employee allocates to the plan that is not spent by the end of the year is forfeited.
If an employee uses up their full allocation of plan contributions and then leaves the company during the year, then the employer has to absorb the loss of unpaid contributions.
What Is a 401(k) Plan?
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A 401(k) is an account offered by an employer designed to help employees save funds for retirement.
It differs from a savings account or an IRA (Individual Retirement Account) in that it offers a set of investment opportunities that your employer selects.
These can be in the form of stock and bond mutual funds, guaranteed investment contracts (GICs), target-date funds, and your employer’s own stock.
With this plan, you can regularly contribute a portion of your income, usually monthly, to buying investments within the 401(k) that go into the account and become available at retirement.
Depending on the type of 401(k) plan you choose to take advantage of, you will either be taxed when you contribute to your 401(k) or when you pull money out.
The 401(k) retirement savings account got its name from the Revenue Act of 1978, where an addition to the Internal Revenue Services (IRS) code was added in section 401(k).
Consequently, 401(k) does not stand for anything except for the section of IRS tax code it was created in.
Traditional 401(k) vs Roth 401(k)
There are two types of 401(k) plans: Traditional and Roth 401(k)s.
The traditional 401(k), named after the relevant section of the IRS code, has been around since 1978.
With this plan, any contributions you make to the 401(k) account will reduce your income taxes for that year and will be taxed when they are withdrawn.
Roth 401(k)s, named after former senator William Roth of Delaware, were introduced in 2006.
Unlike a traditional 401(k), all contributions are made with after-tax dollars and the funds in the Roth 401(k) account accrue tax free.
Typically, employees can take advantage of both plans at the same time, which is recommended among financial advisors to maximize retirement savings.
Because of the way the contribution limits work, it is possible to invest different amounts into each account, even year-to-year, so long as the total contribution does not exceed the set limit.
401(k) Retirement Plan
If your employer offers both types of 401(k) accounts, then you will most likely be able to contribute to either or both at your discretion.
To reiterate, with a traditional 401(k), making a contribution reduces your income taxes for that year, saving you money in the short term, but the funds will be taxed when they are withdrawn.
With a Roth 401(k), your contributions can be made only after taxation, which costs more in the short term, but the funds will be tax free when you withdraw them.
Because of this, deciding which plan will benefit you more involves figuring out in what tax bracket you will be when you retire.
If you expect to be in a lower tax bracket upon retirement, then a traditional 401(k) may help you more in the long term.
You will be able to take advantage of the immediate tax break while your taxes are higher, while minimizing the portion taken out of your withdrawal once you move to a lower tax bracket.
On the other hand, a Roth 401(k) may be more advantageous if you expect the opposite to be true.
In that case, you can opt to bite the bullet on heavy taxation today, but avoid a higher tax burden if your tax bracket moves up.
Check out this article from Forbes to see the IRS tax rate tables for 2020, but remember that they are subject to change.
A smart move may be to hedge your bets and divide your contributions between the two types of IRAs.
If your employer allows you to add funds to both a traditional and Roth 401(k), then doing so reduces the potential risks of each.
In this case, you will also have the ability to decide what proportion of your income goes into each account, meaning that as you near retirement and have a clearer idea of what position you will be in, you can put more into one or the other.
When you do decide which avenue to take, make sure to thoroughly evaluate your decision.
Moving funds from one account to another, such as from a traditional to a Roth 401(k), is time consuming and expensive, if even possible.
Likewise, transferring a 401(k) from one employer to another in the event of a job change is also tricky.
You want to make sure that when you put money into your plan, it will be able to sit undisturbed for a very long time.