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Stop Giving Raises for Health Insurance and Start Offering Defined Contribution Allowances

Defined Contribution Health Plans • January 6, 2014 at 12:00 PM • Written by: Christina Merhar

Many small businesses who do not offer health benefits consider giving employees a raise or salary bonus to help them pay for their individual health insurance.

  • The small business wants to offer health benefits to take care of employees and to help with recruiting and retention, but...
  • They cannot afford group health insurance,

  • They cannot meet minimum participation requirements of a group health insurance plan, and/or

  • They do not know about small businesses health insurance alternatives such as Section 105 defined contribution plans.

On the surface, providing raises or salary bonuses to employees may seem cheaper and simpler than reimbursing health insurance premiums through Section 105 defined contribution allowances. But, there is one major consideration favoring Section 105 defined contribution allowances for small businesses: Tax savings.

Bottom line... By offering Section 105 defined contribution allowances instead of giving raises to employees for health insurance, both the small business and employees save money. 

Employee Raises for Health Insurance vs. Section 105 Defined Contribution Allowances

Here's a look at how Section 105 defined contribution allowances save small businesses taxes compared to giving employees raises or bonuses for their individual health insurance.

  1. The business pays taxes on the raise. A raise or bonus of $300 per month gross actually costs the business $323 per month after FICA/FUTA payroll taxes (7.65%) are factored in. Annually, the business is spending $3,875 to offer a raise/bonus of $3,600.  

  2. Section 105 defined contribution reimbursements are tax-deductible to the business. If the small business gives employees a $300 per month defined contribution allowance (via a Section 105 plan), the real cost to the business is $300 (FICA/FUTA payroll taxes do not apply to the reimbursements). Annually, the business is spending $3,600 to offer a pre-tax benefit of $3,600. 

  3. The employees pay taxes on the raise. Assuming the employee is 1) single, and 2) making $35,000+, the employee will pay $1,175 of the $3,600 in taxes ($3,600 x 32.65%*). Annually, the business is spending $3,875 to offer an after-tax ("take home") bonus of $2,425.  

    *Assumes a 25% marginal tax rate + 7.65% FICA/FUTA

  4. Section 105 defined contribution reimbursements are 100% tax-free to employees. Because of this, $1 in defined contribution allowance funds is worth approximately $1.50 - $2.00 in a taxable bonus (depending on the employee's tax bracket). With Section 105 defined contribution allowances, the business is then spending $3,600 annually to offer a pre-tax benefit of $3,600, which translates in value to $5,400 - $7,200 in a taxable bonus.

  5. With a raise or bonus, it's not guaranteed employees will spend the money on health care expenses.

    Section 105 defined contribution allowances only reimburse for eligible health insurance expenses, within the terms of the plan documents. Employees are only reimbursed from their defined contribution allowance once they show proof of their premium expense. And, employees are only reimbursed up to the amount of their allowance. For example, in the case of a $300 per month allowance, if the employee's health insurance only costs $210 per month, the plan only reimburses $210 per month. The remaining $90 per month stays with the company.

How Section 105 Defined Contribution Allowances Work

If you're not familiar with how Section 105 defined contribution allowances work, here is a quick overview. With defined contribution allowances:

  • The employer provides each employee a fixed monthly allowance (a group health insurance plan is not offered).

  • Employees select and purchase any individual health insurance policy, and pays for the policy directly.

  • Employees use their defined contribution allowance to reimburse themselves for their insurance premium, up to the amount of their allowance.

  • Because the defined contribution allowances are set up using an IRS-approved Section 105 plan, the reimbursements are tax deductible to the business and 100% tax-free to employees (as discussed above).

Section 105 defined contribution allowances are usually set up and administered through a defined contribution administrator to ensure compliance with federal regulations (ACA, ERISA, HIPAA, and IRS).

Read more about defined contribution health plans here.

Additional Benefits of Section 105 Defined Contribution Allowances

In addition to the cost and tax savings for the small business and employees, offering Section 105 defined contribution allowances instead of taxable salary increases for health insurance puts into place a formal health benefits program. 

Formal health benefits programs are more likely to show that the business cares about employees, and helps recruit and retain key employees as the small business grows. That's because:

  • Employees understand the exact parameters of the plan (these plan details and benefits can be presented to candidates in an offer letter).

  • Employees are reminded of the benefit on their pay check (they see a line-item each pay period, versus the amount being rolled into their gross earnings).

  • Employees perceive fairness and accountability in the benefits program.

So for these reasons, all small businesses should stop giving bonuses or raises to employees for health insurance and start directing this money through Section 105 defined contribution allowances.

Your bottom line (and employees) will thank you.

Questions about Section 105 defined contribution allowances? Leave a comment below.

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Christina Merhar