Reminder: Nondiscrimination Testing Required for Cafeteria Plans

reminder finger

Employers, regardless of size, who provide a cafeteria plan (also known as a Section 125 plan) are required to perform nondiscrimination testing (NDT) as of the last day of their plan year. 

Definition: In general, Section 125(d)(1) defines the term “cafeteria plan” as a written plan under which— (A) all participants are employees, and (B) the participants may choose among 2 or more benefits consisting of cash and qualified benefits. 

In other words, a cafeteria plan is what permits employees to pay for qualified benefits, such as group health insurance, on a pretax basis, reducing both the employees’ and the employer’s tax liability.

However, in order for the employer (and employee) to receive the tax advantages associated with a cafeteria plan, the Internal Revenue Code (IRC) requires testing to ensure highly compensated employees (defined as $125,000 for 2019 plan year testing) and other individuals key to the business (i.e. officers, more than 5% shareholders or spouse/dependent of the highly compensated employees or these key individuals) do not receive a more favorable tax treatment (i.e. does not discriminate in favor of highly compensated employees).

Although the Section 125 rules only require an employer test “as of the last day of the plan year”, corrections are not allowed to be made retroactively after the plan year ends. Therefore, best practice is for a plan to be tested more than once, allowing an employer to possibly make adjustments to ensure the plan passes at the end of the year to preserve the tax treatment for the highly compensated and key employees. Otherwise, if a plan fails (i.e. found discriminatory) at the end of the year, the affected employees would be taxed on their total election amount.

If you haven’t ran your nondiscrimination tests, now would be a good time to engage a qualified vendor or legal counsel to perform the applicable nondiscrimination testing and possibly detect potential problems that may be resolved before the end of the plan year.

NOTE:  In addition to Section 125 NDT, the IRS Code requires other nondiscrimination testing to be done annually too. For instance, employers who sponsor a health FSA, which is considered a self-insured health plan, would be subject to both Section 125 & Section 105(h) testing, their dependent care FSA would be subject to Code Section 125 & Section 129 NDT.


Not All Cafeteria Plans Are The Same


cafeteria plan is a mechanism that offers employees a choice between cash (i.e. their full salary as taxable income) or non-taxable qualified benefits (i.e. allows employees to pay with pre-tax dollars.)  All cafeteria plans are salary reduction plans based on Internal Revenue Code §125, however, there are many plan design variations and not all cafeteria plans are the same.

A Premium Only Plan (POP, also sometimes called a Premium Conversion Plan, PCP) is the simplest form of a cafeteria plan under IRS Code §125. It’s a “premium payment plan” and allows for employers to take certain employee paid premiums for insurance benefits pretax. (e.g. group health, dental, vision)

When you have a health and/or dependent care flexible spending account (FSA), that goes beyond the premium payment plan format because you are permitting employees to reduce their salaries before taxes to reimburse medical/childcare expenses.

In addition to the “rules” under IRS Code §125 found in a POP plan, FSAs are subject to special requirements contained in other IRS regulations.

Health FSAs are subject to requirements under Code §105 (self-insured medical reimbursement plans) Code §106 (the requirements for accident and health plans) and Code §125.

Dependent Care FSAs are subject to requirements under Code §129 (“Dependent care assistance programs”) and various special FSA requirements in Code §125 and IRS regulations. 

Therefore you need a more complex cafeteria plan document (often called a flexible spending plan) than a POP document to be in compliance when offering an FSA.  

The most complex form of a cafeteria plan, sometimes referred to as a “full flex” plan is where an employer provides employees “flex credits” to “spend” on qualified benefits. Depending on the plan design, the employee may be eligible to receive in cash, taxable compensation if the employee doesn’t “spend” all of his flex credits on benefits.


One requirement that every cafeteria plan must meet, is having a written plan document that includes all content specified in the IRS code. e.g. participation rules, election and election change procedures, manner of contributions, etc. 

While it is permissible to have separate cafeteria plan documents. i.e. a POP plan document for the insurance premiums and a separate cafeteria plan document for an FSA, for ease of administration most will include a POP component with in their flexible spending plan document.

According to the 2007 proposed cafeteria plan regulations (Treas. Reg. §1.125-1(c)(6))

(6) Failure to satisfy written plan requirements. If there is no written cafeteria plan, or if the written plan fails to satisfy any of the requirements in this paragraph (c) (including cross-referenced requirements), the plan is not a cafeteria plan and an employee’s election between taxable and nontaxable benefits results in gross income to the employee.

In simple terms, failure to have a written plan document employees would be treated as if they had a taxable benefit (e.g wages) even though they received a nontaxable benefit (e.g. health insurance).

The cafeteria plan document is what allows pretax salary reductions and contains the rules the IRS permits. It’s an important document to have and to understand.




Healthcare FSAs Uniform Coverage Rule – an Employer’s Risk


Under the uniform coverage rule, the full amount an employee elects under a health flexible spending account (health FSA), must be available from the first day of the plan year and must remain available at all times during the coverage period. It requires employers to reimburse expenses up to the full employee health FSA election amount, even if such reimbursements exceed the employee’s year-to-date contributions.

This means an employee can potentially terminate employment having been reimbursed under the health FSA for more than they contributed up to the time of their termination.


  • Tom enrolls for the first time in his employer’s health FSA, electing the full 2019 IRS limit of $2,700 for their April 1, 2019 – March 31, 2020 plan year.  Tom resigns effective April 30, 2019. By the end of that month, he has paid $225 into his health FSA account via salary reductions. On his last day of work (April 30, 2019), Tom submits a claim to be reimbursed for $1,900 of medical expenses that he incurred for his sons recent surgery on April 22, 2019. Tom’s employer must reimburse the full $1,900, even though he only contributed $225 before his employment ended (assuming the expenses are adequately substantiated) and the employer may not recoup the difference. 
  • Mary enrolls in her employer’s calendar year (1/1- 12/31) health FSA, electing the full 2019 IRS limit of $2,700. Mary is paid semimonthly. Throughout the year, Mary submits medical expenses totaling the full amount of $2,700.  Mary resigns effective 11/15, leaving her health FSA overspent (i.e. more was reimbursed than contributed via payroll deduction) by $337.50. Mary’s employer may not withdraw the balance from her last paycheck. 

The uniform coverage rule is part of the risk an employer takes when establishing a health FSA.  The point of the rule is that the employer must bear the risk of loss (i.e. operate like an insurance plan, rather than a mere reimbursement account) in order for the arrangement to qualify as a health FSA.

Although the uniform coverage rule is a risk, in my experience, most employers with health FSAs when looking at the plan year as a whole, do not pay out more in claim reimbursements than they receive in employee contributions. In fact, because of the risk of the  ‘use it or lose it rule’ for employees which generally requires employees forfeit to the employer any unused amounts left in their accounts at the end of the plan year, most employers total contributions exceed total reimbursements for the year.


Mistakes happen!


Even HR & Benefit professionals with excellent processes in place to follow the rules for cafeteria plan administration, may stumble upon a mistake.  I probably receive a question at least monthly, on some type of oversight.

For instance, most recently I received an email from an employer who discovered during a payroll audit, they failed to take the correct amount of premiums from an employee’s paycheck per the terms of the salary redirection agreement (e.g. enrollment form) signed by the employee during open enrollment. The employee was enrolled in the correct benefits with the carriers effective 1/1 but somehow the wrong employee pretax deductions occurred and too little premium withheld.

Unfortunately, there really aren’t IRS regulations or guidance addressing what to do when a mistake like this occurs (they only address a few narrow areas). However, my understanding of “cafeteria plan administrative errors” corrections is generally, an employer will want to correct the mistake so the employee and the plan are put back into the position they would have been in had the mistake never occurred.

For example, knowing there hadn’t been enough money withheld, the employer would want to let the employee know an oversight occurred and depending on the amount of the money needed to be made up, either ask for the employee to pay the entire amount or perhaps have double-premiums deducted until the shortfall is corrected.

However, whenever a mistake is discovered, and yes mistakes do happen, the best course of action is to contact an experienced benefits attorney, who can provide legal advice before implementing corrections to ensure all federal & state wage/tax laws are considered. (Let me know if you need one. I can refer you to the best!)