Nondiscrimination testing in Section 125 cafeteria plans

For pre-tax cafeteria plans to remain compliant, thorough Section 125 nondiscrimination testing is a key component. The IRS code governing cafeteria plans requires that testing for discrimination among plan participants occur annually.

Since cafeteria plans allow for pre-tax contributions, keeping them compliant with IRS law is vital. This rule applies to health insurance premiums, health savings accounts (HSAs), flexible spending accounts (FSAs), limited-purpose flexible spending accounts (LPFSAs), and dependent care accounts (DCFSAs).

Let’s break down the 5 Ws — who, what, when, where, and why — of Section 125 compliance testing and how Omnify can help simplify this process for your benefits team.

Who is required to do this plan testing?

All employers who allow for pre-tax payroll deductions for employer-sponsored health plans must do annual Section 125 nondiscrimination testing. This includes public and private companies, regardless of size, with no exceptions. If your company has a pre-tax cafeteria plan, Section 125 testing is mandatory.

What is Section 125 testing?

Employers must satisfy tests that look at eligibility and coverage in cafeteria plan operation to make sure that plan design and document provisions prohibit discrimination. The nondiscrimination testing compares benefits between key and non-key employees, as well as benefits between highly compensated and non-highly compensated employees. It also compares DCFSA between owners and non-owners.

Several questions must be answered in this testing:

• Is the cafeteria plan available to everyone who meets eligibility criteria?
• Does eligibility differ based on objective business criteria?
• Are contributions identical between highly compensated and non-highly compensated employees?
• Can all eligible employees elect the same level of benefits?
• Are the waiting periods the same between highly compensated and non-highly compensated employees?
• Is DCFSA eligibility the same for all eligible employees?
• Can all eligible employees elect the same DCFSA benefits and contribute the same amount?

Under the contributions and benefits testing of Section 125, a comparison is made between the total pre-tax benefits received as a percentage of compensation between highly compensated and non-highly compensated employees. The highly compensated ratio must be less than or equal to the non-highly compensated ratio. Problems with compliance can exist if highly compensated employees are taking advantage of the pre-tax benefits of the plan but non-highly compensated employees are not.

When does testing need to be done?

IRS regulations state that any employer offering a Section 125 plan should complete nondiscrimination compliance testing on an annual basis. We offer nondiscrimination testing to our employer groups every year to determine who would like us to complete this testing on their behalf.

We recommend that testing should be completed around 1-3 months before the plan year ends. Testing during this time frame provides fairly accurate reporting for the plan year, while also allowing time for corrections to be made if one or more of the tests fail. There may also be times when it makes sense to test a plan earlier in the year. This pre-testing option can help catch potential failures earlier, allowing even more time for adjustments to be made.

There is no time limit for when testing can be completed for a plan year, so it is also possible to test after the end of the plan year if necessary. However, it is important to keep in mind that any corrections or adjustments made to the plan must be completed by the last day of the plan year, so it is not possible to make corrections if testing is completed after the plan year ends.

It’s also important to do testing after open enrollment if testing issues have been found in the past for the plan.

Where does testing happen?

Luckily, your testing can happen right here at Omnify. Our Section 125 experts can test the plan for you and take care of any compliance issues in-house. Many of our employer groups opt for this service, which simplifies the management of their plans. We perform tests that look at FSA and LPFSA elections, as well as DCFSA election testing.

Why is this testing necessary?

Cafeteria plan nondiscrimination testing is important to determine if a plan unjustly favors highly-compensated individuals, key employees, or owners within an organization. Because Section 125 plans allow employees to pay for certain benefits on a pre-tax basis (which saves money for both the employee and the employer), the employer must ensure that the benefits are offered equitably to all eligible employees and that the benefits are not being disproportionately elected by the highly compensated and key employee groups. 

In the event of a testing failure, the highly compensated or key employees enrolled in the benefits included in the failed test lose the pre-tax status on contributions for those benefits. A tax professional or legal agent should be consulted for any compliance tests failures.

We’re here to help!

At Omnify, we take compliance seriously. Our goal is to keep our employers’ plan in compliance from start to finish, so if our employers receive a failing test result, Omnify will work closely with them to determine if making corrections will bring the plan into compliance, as what those corrections would look like. If you ever have any questions regarding nondiscrimination compliance testing, we encourage you to reach out to the Omnify team.  

If you or your benefits team has Section 125 testing questions, reach out and we’ll be happy to answer them!