Cafeteria plans provide an IRS-approved way to lower taxes for both employers and employees. Also known as Section 125 Plans, cafeteria plans allow employees to redirect compensation to pay for qualified unreimbursed medical expenses, dependent care expenses, certain insurance premium contributions, and adoption expenses before personal taxes are computed on their paychecks. Employees end up paying pay less taxes because their taxable income is lower.

Employees also don't have to pay Social Security tax on amounts placed in their cafeteria plan accounts. This means the business saves taxes as well, because it pays less in Social Security matching funds.

While sole proprietors, partners, members of an LLC or LLP (in most cases), and individuals owning more than 2% of an S corporation may not participate in a cafeteria plan, they may still sponsor a plan and benefit from the savings on payroll taxes attributable to other employees.

For a full-scale look at the advantages of sponsoring a cafeteria plan, click here.

Unreimbursed Medical Expenses

Unreimbursed medical expenses are those which are not covered by an insurance plan. Under current law, only expenses that exceed a deduction floor of 7.5% of AGI are deductible.

With a cafeteria plan, most medical expenses become, essentially, tax deductible. Covered expenses include insurance deductibles and co-pays, doctor's office visits, dental and orthodontia expenses, vision care, eye surgery, prescription drugs, and medical transportation costs.

Dependent Care

Many cafeteria plans allow employees to pay for up to $5,000 of child and adult dependent care expenses each year with pre-tax dollars. Generally, a child or dependent must be younger than 13 or disabled for them to qualify.

Dependent care expenses paid through a cafeteria plan will reduce the amount of the taxpayer's Child and Dependent Care Tax Credit on a dollar-for-dollar basis.

Set up a cafeteria plan to allow employees to pay for their dependent care expenses. This will likely save them more tax dollars than they would with the child care tax credit.

Health Insurance Premiums

Many employees must pay for a portion of their employer-sponsored health insurance premiums. By allowing employees to deduct their premiums from their pay on a pre-tax basis through a cafeteria plan, the employer can save on taxes. In fact, for every dollar employees spend on health insurance, the employer saves 7.65%, or the FICA match.

Premium Only Plans are simple to set up and easy to administer, and unlike other types of cafeteria plans, they do not require filing claims or an IRS tax filing.

Adoption Assistance

Employees adopting a child can be reimbursed through a cafeteria plan for up to $12,150 in 2009.

Employees can only take the reimbursement once per child. If the adoption process spans several years, employees need to consider which year will be best for this reimbursement.

Your employees may benefit by using the adoption assistance as a tax credit. The $12,150 limit is the same as if the reimbursement is filed through a cafeteria plan. If the eligible expenses exceed $12,150, both the cafeteria plan and the tax credit may be utilized. If employees are in the 25% tax bracket or higher, paying for adoption expenses through the cafeteria plan will likely save them more than the credit. The tax credit gradually phases out based on adjusted gross income. To see if you qualify, click here.