How to Perform Section 125 Non-Discrimination Testing
Navigate Section 125 compliance. Understand the critical steps to assess your employee benefit plan's equity and tax status.
Navigate Section 125 compliance. Understand the critical steps to assess your employee benefit plan's equity and tax status.
Section 125 cafeteria plans allow employees to choose between taxable cash and non-taxable benefits like health insurance or flexible spending accounts. This offers tax advantages for both employees and employers, as pre-tax deductions reduce taxable income and payroll tax obligations. To ensure equitable distribution and prevent disproportionate favoring of highly compensated individuals, the Internal Revenue Service (IRS) mandates annual non-discrimination testing. These tests confirm the plan operates fairly, preventing designs that primarily benefit a select group of highly paid employees or business owners, which would undermine the tax-advantaged structure. Understanding and performing these tests are fundamental for maintaining a Section 125 plan’s tax-favored status, involving identifying employee categories, understanding tests, collecting data, performing calculations, and addressing non-compliance.
Correctly identifying employee categories is the first step for accurate Section 125 non-discrimination testing. These classifications determine which employees are included in specific tests and how their benefits are evaluated.
Highly Compensated Employees (HCEs) are a group the non-discrimination rules aim to prevent from receiving disproportionate benefits. For the 2025 plan year, an employee is classified as an HCE if they owned more than 5% of the business in the current or preceding plan year, or earned over $160,000 in compensation in the preceding plan year (2024).
Non-Highly Compensated Employees (NHCEs) are all employees who do not meet the HCE criteria. This group typically comprises the majority of an employer’s workforce.
Key Employees are a distinct category, relevant for the Key Employee Concentration Test. For the 2025 plan year, a Key Employee is an officer whose compensation exceeded $230,000 in the preceding plan year, or an individual who owned more than 5% of the business in the current or preceding plan year.
Certain employees may be excludable from non-discrimination testing if the plan document allows. Common excludable categories include employees who have not met minimum service requirements, employees under a certain age, part-time or seasonal employees, and employees covered by a collective bargaining agreement. However, if an otherwise excludable employee is eligible for and participating in the plan, they must be included in the testing.
Section 125 plans must satisfy several non-discrimination tests to maintain their tax-favored status. These tests focus on eligibility, contributions, benefits, and concentration among key personnel.
The Eligibility Test assesses whether a sufficient number of non-highly compensated employees can participate. A plan generally passes if the percentage of eligible NHCEs is at least 50% of the percentage of eligible HCEs.
The Contributions and Benefits Test evaluates if the plan provides contributions and benefits on a non-discriminatory basis. This test considers the value of benefits relative to compensation.
The Key Employee Concentration Test prevents key employees from receiving an excessive share of total non-taxable benefits.
Beyond these core tests, additional non-discrimination tests apply to specific benefits within a Section 125 plan. For example, Health Flexible Spending Accounts (FSAs) and Dependent Care Flexible Spending Accounts (DCFSAs) have separate eligibility and benefits tests, ensuring each component adheres to non-discriminatory principles.
Employers must meticulously gather specific data and documentation for all employees before performing non-discrimination tests. The accuracy and completeness of this information are paramount, as errors or omissions can lead to incorrect test results and potential compliance issues.
This includes hire dates, termination dates, and full-time or part-time employment status for the plan year. This data identifies excludable employees and determines eligibility periods. Accurate demographic data forms the baseline for all subsequent calculations.
Compensation data for every employee is critical, typically covering the prior plan year for HCE and Key Employee identification. This includes all forms of compensation, such as wages, salaries, bonuses, commissions, and even salary deferrals to pre-tax plans. Precise figures are essential for classifying employees and calculating benefit-to-compensation ratios.
Detailed plan enrollment data is required, indicating which employees were eligible and which elected to participate. This information helps verify that the plan’s eligibility rules are being applied consistently and that employees are properly categorized for testing purposes.
Specific election data for each benefit offered through the cafeteria plan must be collected. This includes the exact pre-tax benefits chosen by each employee and the corresponding dollar amounts. For example, the elected amounts for health insurance premiums, health savings account (HSA) contributions, and flexible spending accounts are all necessary.
Contribution data, encompassing both employer and employee contributions to various benefits, is vital. This includes any employer contributions made on behalf of employees, as well as employee contributions made through salary reduction elections under the plan.
The official plan document details are indispensable. This document outlines the specific eligibility rules, benefit offerings, and operational procedures. Reviewing the plan document ensures that the data collected and the tests performed align with the plan’s stated terms and conditions.
Performing non-discrimination tests involves a precise, step-by-step application of rules to the gathered data. The accuracy of these calculations directly determines the plan’s compliance status.
First, identify all non-excludable employees for the plan year. Determine how many of these are eligible to participate, distinguishing between Highly Compensated Employees (HCEs) and Non-Highly Compensated Employees (NHCEs). Calculate the percentage of eligible NHCEs out of total non-excludable NHCEs, and similarly for HCEs. To pass, the percentage of eligible NHCEs must be at least 50% of the percentage of eligible HCEs.
Calculate the aggregate non-taxable benefits elected by all HCEs and their total compensation. Divide HCEs’ total non-taxable benefits by their total compensation to find their average benefit-to-compensation ratio. Repeat this for all NHCEs. The plan passes if the average contributions and benefits for NHCEs are at least 75% of the average for HCEs.
Identify all Key Employees. Sum the total non-taxable benefits elected by all Key Employees. Separately, calculate the total non-taxable benefits elected by all employees participating in the plan. Divide the total non-taxable benefits for Key Employees by the total for all employees. This percentage must not exceed 25% for the plan to pass.
These calculations are typically performed annually after the plan year concludes when all data is finalized. The results are not filed with a government agency but must be kept on file and made available for an IRS audit.
The outcome of non-discrimination tests dictates the next steps for a Section 125 plan, determining if it remains compliant or requires corrective action. Understanding these implications is essential for effective plan administration.
If a Section 125 plan passes all tests, it complies with IRS regulations. In this favorable scenario, all employees, including Highly Compensated Employees (HCEs) and Key Employees, can continue to enjoy the tax-free benefits offered through the plan. No further action is required beyond retaining documentation of the successful tests.
If one or more tests fail, the plan is considered discriminatory. The tax-favored status of benefits for HCEs and Key Employees is jeopardized. Specifically, the non-taxable benefits received by these individuals may become taxable income, meaning they would be included in their gross income for federal income tax purposes. Non-Highly Compensated Employees do not lose their tax benefits if the plan fails.
To remedy a failed test and avoid tax consequences for HCEs and Key Employees, employers can take corrective actions. One common method is to reduce the pre-tax benefits elected by HCEs. This might involve recharacterizing a portion of their pre-tax benefits as taxable income, effectively “cashing out” the excess benefit. Another approach is to increase the benefits for NHCEs, which can involve making additional employer contributions or encouraging higher participation rates among this group.
Corrective actions must typically be implemented by the end of the plan year in which the failure occurred. If corrections are not made within this deadline, the tax implications for HCEs and Key Employees become certain.