July, 2003 Tax Newsletter

Tax Treatments of Employee Benefits

Tax laws support many employee benefits by way of preferential tax treatment in the Internal Revenue Code.

There are three types of tax treatments for employee benefits: tax exemption, tax deferral, and other preferential treatment:

Tax-exempt treatment in the tax code means that the benefit will never be considered taxable income to the individual while, at the same time, it generally provides a tax deduction to the employer.  Examples of benefits that receive this type of tax treatment are health insurance, educational assistance, legal assistance, child-care, discounts, flexible spending accounts, parking and, in some cases, meals.  The largest of these by far is health insurance.  The revenue loss to the government from these benefits will not be recouped in the future.

Tax-deferred treatment means that the employee is not immediately taxed on (1) the contributions the employer and/or the employee makes to the plan, and/or (2) on the earnings on plan assets as they accumulate but, rather, will typically be taxed on previously untaxed amounts when the benefit is paid.  Examples of employee benefits that receive this type of tax treatment are Keogh plans, defined benefit pension plans, defined contribution plans (such as 401(k) plans), and individual retirement accounts (IRAs).  As with the exempt items, the employer is allowed a tax deduction for the contributions.  However, the revenue loss from these contributions and earnings is different from health insurance and other tax-exempt items.  The tax revenue loss here is actually a deferral of taxation, rather than an exemption.  At some point in the future, when the individual starts drawing a benefit from the plan, the federal government will receive some tax revenue from the benefit payment.

Other-benefits are subject to partial preferential tax treatment.  For example, employer payments for the premium on employee life insurance are tax-exempt to the employee up to an insurance benefit of $50,000.  Any additional premium amount paid by the employer to provide a benefit greater than $50,000 is taxable income to the employee.  However, there are tables that provide for favorable premium rates that apply to the taxable portion.  Moreover, the benefit payout from a life insurance policy is not taxable income to the beneficiary.