Tax Considerations

Employee Benefits 

Some of your employee benefits may be treated as taxable income. Generally, the IRS treats most fringe benefits as taxable income.

However, many of these benefits have dollar limits that may be excluded from your income. Fringe benefits are those benefits you receive without paying a fair market value for them. Box 1 of your W-2 statement shows your ordinary income. The value of any fringe benefits your employer gives you is included in the total for Box 1. Total value of your fringe benefits may also be shown separately in Box 12 or Box 14.

For more on understanding your W-2 statement, see the informational copy of the statement for 2010 at the IRS Web site.

As we've discussed, some employee benefits are excluded from your taxable income. For example, the first $5,250 of employer-paid educational assistance may be excluded. Here are some examples of the types of fringe benefits and their tax treatment:

Transportation expenses. For 2011, you may exclude the first $230 a month your employer pays for qualified car pool or mass-transit expenses, and the first $230 for qualified parking expenses, or a combination as long as the total isn't more than $230 per month. Amounts paid in excess of these must be included as taxable income.

Group term life insurance. Employers often provide group life insurance. Premiums paid on the first $50,000 of group term life insurance may be excluded. If you receive more than $50,000 in coverage, the amount of employer-paid premiums for the additional coverage must be included as taxable income.

Cafeteria plans. While there are no explicit limits on how much you may contribute to a health care reimbursement account using a cafeteria plan, your employer must limit contributions to a dependent care reimbursement account to $5,000. Generally, contributions that are less than the contribution limit may be excluded from your taxable income.

If an amount is shown in Box 10 of your W-2, you must complete Form 2441. These forms are used to calculate how much of your dependent care benefits must be included as taxable income.

Distributions from nonqualified retirement plans. Money that you receive from a nonqualified deferred compensation plan must be included in income. Examples of qualified retirement plans include 401(k), 403(b) and 457 plans.

Certain disability benefits. Disability benefits are generally taxable if either your employer paid the insurance premiums or you paid the premiums with pretax dollars (such as with a cafeteria plan). Disability benefits earned from most government disability pensions, including those from a VA pension, are excluded from income.

Long-term care benefits below a certain amount. Benefits you receive on a long-term care insurance policy are excluded from income.

Finally, it's worth mentioning taxation of stock options.

The two types of employee stock-options are nonqualified and incentive stock options. If you hold nonqualified stock options, you will have to include as income the difference between the fair market value of the shares and the exercise price when you exercise the options. With incentive stock options, you include this difference as income when you sell the shares you obtained from exercising your options.

For example, assume you were granted 500 nonqualified options. Each option can be exercised for 10 shares, for a total of 5,000 shares. If the share's market price is higher than the exercise price, you can exercise the shares and sell them at the higher market price for a profit.

If the exercise price on the nonqualified options was $20 and market price was $30, you would create a tax liability on $50,000 [5,000 shares * ($30 - $20)] of income when you exercise the options.

In fact, this is what some dot-com employees did during the Internet heyday of the late 1990s. A few unlucky employees exercised incentive stock options but didn't sell the shares in time to earn a large enough profit to pay the alternative minimum tax.

The above information should not be interpreted as financial advice. For advice that is specific to your circumstances, you may wish to consult a financial or tax adviser.