We have learned a lot these last few months here at Max Out of Pocket. Since Max OOP is just an average Joe Max, we prefer to keep things in nice, bite-sized chunks where we can. Hopefully that works out for everyone as we take a trip through the cafeteria today and pick up some medical insurance.
With an initial focus on FICA payroll taxes, we learned that most Max Out of Pocket readers likely pay 1.45% of their earned wages to the Medicare program and another 6.2% into the Social Security Trust Fund. This totals 7.65% and your employer pays an equal 7.65% in FICA taxes for a grand total of 15.3%. So in theory, a total of 15.3% of your ‘efforts’ are technically going to the federal government one way or another in the form of FICA payroll taxes. There is no cap on Medicare (that tax actually increases) and Social Security is capped at $132,900 (CY19) if you are lucky enough to be at that level of income.
So, for every $100 in earned income you make, $7.65 goes to payroll taxes.
“Okay Max OOP, haven’t we covered this enough already?”
Cafeteria Plans – A Basic Overview
Cafeteria Plans can shelter you from the FICA payroll taxes. In other words, if you pay for or receive qualified benefits outlined by the IRS, you do not have to pay the 7.65% tax on that benefit. These benefit plans must meet specific requirements and regulations of section 125 of the Internal Revenue Code.
A Cafeteria Plan is a separate written plan drawn up by an employer for employees to receive certain qualified benefits. The IRS decides which benefits are qualified and lists them out on this nice little FAQ document. Here they are!
- Accident and health benefits (but not Archer medical savings accounts or long-term care insurance)
- Adoption assistance
- Dependent care assistance
- Group-term life insurance coverage
- Health savings accounts, including distributions to pay long-term care services
We are going to zero right in on that health benefits bullet since that is our bread a butter here at Max Out of Pocket. Don’t worry, we will hit the almighty HSA (Health Savings Account) another day.
Walking Through The Cafeteria
The Cafeteria Plan does not actually provide health insurance; it is a mechanism to pay for health insurance. Health benefits include things like medical, dental, and vision insurance. Picture yourself walking through a cafeteria and picking and choosing which health benefit plan you want from your employer and which you don’t. You may already know this, but in most cases, it isn’t a requirement to sign up.
Let’s say Max OOP walks through the cafeteria and picks up a nice looking medical insurance policy to go with my healthy granola. I hit the register and the price tag is $2,600 in annual premiums through my Cafeteria Plan to cover my portion of the medical insurance premium. Oh, and the granola was like $2.25. When I sign up for this benefit through my employer, I agree to let my employer take this amount out of each paycheck over 26 pay periods. Coincidentally, this comes out to an even $100 out of each paycheck in this fairy tale example. In reality, I pay much more than that in medical premiums, but didn’t want to give anyone nightmares.
Give Me Some Shelter
The thing is, this $100 in earned income actually never makes it into my pocket. My employer takes the $100 and pays it directly to my insurance company. Therefore, these premiums are not considered earned income for federal payroll tax purposes and they don’t take out the $7.65. They actually back the premiums out of the calculation before multiplying everything by 7.65% to figure out my total FICA tax due. Thus, we get to shelter $199 in FICA taxes on these $2,600 in premiums over the course of the year.
$2,600 Medical Premium X 7.65% FICA Tax = $199 Sheltered
But if I were to waive health insurance all together (not recommended), it wouldn’t put all $2,600 back in my pocket. This is because I would lose the shelter and have to pay $199 to FICA since the $2,600 would now be considered earned income. So if I opted out, I would be left with only $2,401 after FICA payroll. If Max OOP found himself with an extra $2,400 in my pocket, I would probably invest it into medical office buildings.
Actually, if you look back at my $12 paycheck from earlier this year, you will notice that my employer took my gross pay and backed out my medical and dental premiums before actually calculating my 7.65% FICA tax. As I mentioned before, front-loading doesn’t stop FICA payroll taxes, but Cafeteria Plans can! It’s just a shot away. It’s just a shot away.
What If I Buy Insurance From The Market Instead Of Going Through My Employer?
This concept is a little more advanced, but I think you can handle it.
What if I am still paying the full $2,600 for health benefits through the open market and not through my employer? My FICA tax in that situation would technically be $215, assuming I am paying the premiums with earned income. In other words, if I were to pay $2,600 for health benefits outside of a Cafeteria Plan using my salary (Dominos pizza anyone?), I would need to earn $2,815, pay $215 in FICA, which leaves me the $2,600 to pay for premiums. This is an important concept to understand once we start trying to compare open market plans to employer subsidized Cafeteria Plans. It is definitely not an apples to apples match.
2,815 earned income X 7.65% = $215 for FICA Taxes
$2,815 – $215 = $2,600 left for medical premiums
Now, if I was retired early and using passive income generated by my medical office building experiment to pay for a market based plan, it technically wouldn’t hit the FICA tax bucket for most of us since it is not considered ‘earned income’.
There is technically even more savings tied to this concept on the regular federal income tax brackets as well (to the tune of 10%-37%), but we will save that for another day since I bet everyone is all numbered out. Bite-sized granola chunks, remember?
There is one nice thing about all of this sheltering from FICA payroll taxes. You usually don’t have to do anything to get the shelter except sign up for health benefits. Your employer should automatically reduce your FICA taxes to account for this tax savings. Don’t worry, you didn’t waste your time reading this thought. If you work for a smaller employer, it wouldn’t hurt to check it out and make sure everything looks correct. We will also need these concepts in our back pocket when we start making strategic decisions as we complete our domination of the US Healthcare system.
Just a reminder, I am not a tax professional so it would be best to check with your employer or the IRS if you have questions about your specific scenario. Now, if you want to hit up the cafeteria and enjoy some granola with Max OOP, feel free to reach out!
Also, if you have anything to add, please share in the comments below!
How much is put back into your pocket with the FICA Shelter?