Section 125 testing: All your “w” questions answered

September 08, 2022

For pre-tax cafeteria plans to remain compliant, thorough Section 125 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 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?

Testing should be performed preliminarily before the plan’s year-end so that corrective measures can occur if any noncompliance is discovered. It’s difficult to fix issues after the plan year — especially if the plan year is at the end of the calendar year and W-2 corrections are involved.

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. Failure to test may result in penalties or taxation of specific employees.

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

  • Personal
  • Omnify
  • Health Benefits

Learning Center articles, guides, blogs, podcasts, and videos are for informational purposes only and are not an advertisement for a product or service. The accuracy and completeness is not guaranteed and does not constitute legal or tax advice. Please consult with your own tax, legal, and financial advisors.