Pick up your cafeteria tray and move down the line to view your choices. “I’ll take a spoonful of medical expenses, a big helping of dependent care expenses and for dessert a slice of that life insurance over there.”

Not the kind of cafeteria you were expecting?

This cafeteria offers choices in how an employee receives his/her compensation. And the non-cash choices can mean tax savings for both the employee and the employer.

There are generally two types of cafeteria plans: premium-only plans and flexible spending arrangements. POPS allow employers to deduct the employee’s share of a company-sponsored insurance premium from the employee’s paycheck before taxes are deducted. FSAs allow employees to set aside a pre-established amount of money to be used for eligible expenses, usually health care costs and dependent care costs. This set-aside is made with pre-tax dollars. Many employers offer both POPs and FSAs.

The health care reform package (the Patient Protection and Affordable Care Act of 2010 and the Health Care and Education Reconciliation Act of 2010) has modified the definition of medical expenses eligible for health FSAs to conform them to the definition used for the medical expense itemized deduction. This means that over-the-counter drugs are excluded unless prescribed by a health care professional. The new law makes an exception for insulin.

This new treatment is effective for tax years beginning after Dec. 31, 2010.

The health care reform package also makes a change for health FSAs effective for tax years beginning after Dec. 31, 2012 whereby a plan must provide a $2,500 maximum salary reduction contribution to the health FSA, or else an employee will be subject to tax on distributions from the health FSA. The $2,500 limitation will be indexed for inflation for tax years beginning after 2013.

Under a dependent care FSA, the maximum salary reduction contribution is $5,000. If an employee has more than $5,000 in dependent care expenses, he/she can use the excess to take the child care credit on their income tax return.

However, he/she cannot take the child care credit for expenses submitted to the dependent care FSA.

Employees must be careful in determining the amounts to include in their FSAs. There is a “use it or lose it” rule where any amounts not used by the employee for eligible expenses during a plan year will be forfeited.

However, the IRS has given employers permission to provide for a grace period of not more than two months and 15 days after the end of the plan year.

If a plan provides a grace period, funds contributed during one year can be used to reimburse expenses incurred in the following year during the grace period.

Employees realize tax benefits because the salary reduction contributions are made with pre-tax dollars, which means the amount of taxes withheld from an employee’s paycheck will be lower. Employers realize tax benefits because employees’ taxable compensation is lower, resulting in lower employment taxes.

As with any employee benefit plan, there are various discrimination and other rules that must be met. Please consult a tax professional if you have questions or would like to set up a cafeteria plan for your business.

Ginga MacLaughlin is a Certified Public Accountant, a Certified Information Technology Professional, and a Certified Information Systems Auditor with the accounting firm Silas Simmons, LLP in Natchez.