Many employers wish to offer group term life insurance as a fringe benefit but find the premiums unaffordable. Under such circumstances, you could provide the coverage and have employees pay the premiums pretax through an existing cafeteria plan. Just be sure you understand the tax impact.
Group term life insurance coverage on employees’ lives can be offered through a cafeteria plan, with employees buying some or all of the coverage with pretax salary reduction contributions. Under IRS regulations, pretax salary reductions:
- Are treated as employer contributions, regardless of the amount of coverage purchased, and
- Aren’t subject to federal income or employment taxes.
And the tax code allows employees to exclude from their gross income the cost of up to $50,000 in employer-provided group term life insurance coverage.
Thus, if your employees buy no more than $50,000 of employer-provided group term life insurance coverage with pretax contributions under your cafeteria plan, they won’t owe federal taxes on the coverage. If your employees purchase more than $50,000 of coverage with pretax contributions under the cafeteria plan, the pretax premiums will still be tax-free, but the value of the coverage exceeding $50,000 will be subject to federal income and FICA taxes.
The taxable value of the excess coverage is determined using its cost as indicated in an IRS table known as “Table I.” The Table I cost of coverage varies based on the employee’s age and may be greater or less than what the employee pays. If any portion of an employee’s premiums are paid on an after-tax basis, the after-tax premiums will reduce the taxable coverage value, dollar for dollar.
The taxable amount is sometimes referred to as “imputed income.” In this case, imputed income isn’t subject to federal income tax withholding, but FICA taxes must be withheld.
Let’s look at an example: If a 42-year-old employee buys $150,000 of group term life insurance coverage under a cafeteria plan with $200 of pretax salary reduction contributions, neither the $200 premium nor the first $50,000 of coverage will be taxed. But the cost (as determined by Table I) of the remaining $100,000 of coverage will be treated as taxable income to the employee. For this employee, the Table I cost of $100,000 of coverage will be $120 per year. So, the employee will be taxed on that amount of imputed income.
If the employee could pay for a portion of the coverage with after-tax contributions, and $100 of the premiums were paid with after-tax contributions, the $100 in after-tax contributions would be subtracted from the $120 Table I cost for the coverage exceeding $50,000. The employee’s imputed income on the $100,000 of excess coverage would then be $20 ($120 minus $100).
Many employees will appreciate the opportunity to buy group term life insurance. Just be prepared to inform them of the tax consequences. Our firm can help you consider this fringe benefit from both budgetary and tax perspectives.