Cafeteria plans, often referred to as "125 Plans" or "Flexible Benefit Plans," offer employers a tax-advantaged way to provide benefits to their employees. These plans allow employees to use pre-tax dollars for various benefits, including medical and dental premiums, as well as flexible spending account (FSA) plan benefits. To maintain compliance with the IRS, cafeteria plans must adhere to specific guidelines, including the requirement of that they are not discriminatory, which is evaluated through nondiscrimination testing.
Nondiscrimination testing, specifically Section 125 nondiscrimination testing, serves the vital role of ensuring that cafeteria plans treat all employees fairly. This means preventing any form of favoritism towards highly compensated employees (HCEs) over non-highly compensated employees (NHCEs) when it comes to accessing and benefiting from tax-advantaged benefits offered by the cafeteria plan.
Employers must conduct various tests and calculations to demonstrate that benefits offered under the cafeteria plan are accessible to all eligible employees on a nondiscriminatory basis. These tests evaluate factors such as plan participation rates, contributions, and benefits received by HCEs compared to NHCEs.
All employers that allow employees to use pre-tax dollars through cafeteria plans must perform nondiscrimination testing. This includes government plans, church plans, and other plans, even if they are not subject to the Employee Retirement Income Security Act (ERISA).
Failure to comply with nondiscrimination rules can have adverse tax consequences for both employers and participating employees. Potential consequences include plan disqualification, tax penalties, or adjustments to employee contributions to rectify any discrimination issues. Compliance is essential to maintain the tax advantages of cafeteria plans and promote fairness among employees.
Cafeteria plans undergo various tests, including those for the plan as a whole and specific tests for underlying benefits like FSAs. This article covers the general cafeteria plan testing and testing for FSAs.
Section 125 Cafeteria Plans allow employees to use pre-tax funds for qualified benefits under the plan. These plans are subject to three nondiscrimination tests:
Depending on the test results, employers may need to make adjustments to plan features, benefits, or contributions.
FSA plans, including Dependent Care Flexible Spending Account (DCFSA) and Health Care Flexible Spending Account (HCFSA) plans, allow employees to put aside pre-tax funds to use to be reimbursed for eligible expenses. the opportunity to save pre-tax dollars and use those dollars to pay for eligible expenses. While these plans provide significant savings, it's crucial for employers to ensure they comply with nondiscrimination rules.
A Dependent Day Care FSA enables an employee to set aside pre-tax funds to pay for qualified dependent day care expenses, including childcare or eldercare. To maintain fairness among all employees, DCFSA plans are subject to the following four nondiscrimination tests:
A highly compensated employee for DCFSA testing is a more than 5% owner of the company during the current or preceding year, or an individual with compensation during the preceding year over the IRS dollar limit. An employee who earns more than $150,000 in 2023 is a highly compensated employee for 2024. An employee who earned more than $133,000 in 2022 is a highly compensated employee in 2023.
To pass these tests, employers may need to adjust plan features, contribution limits, or communication strategies to encourage broader participation among NHCEs.
Health Care Flexible Spending Account (HCFSA) plans allow employees to set aside pre-tax funds to pay for medical expenses not covered by insurance. To maintain equity in HCFSA plan benefits, the following two nondiscrimination tests apply:
Adhering to these tests requires employers to carefully monitor contributions and benefits for different employee groups and make adjustments if needed to maintain compliance.
For HCFSA testing purposes, a highly compensated individual is (a) one of the five highest-paid offers; (b) a more than 10% shareholder of the company; or (c) among the highest paid 25% of all employees (other than non-participant excludable employees).
If a 125 Plan, DCFSA or HCFSA plan fails to meet the nondiscrimination tests, there can be significant repercussions. The plan may lose its tax-favored status, leading to employees' contributions becoming taxable. Additionally, corrective actions must be taken swiftly to address the discrimination issue.
Employers can take proactive measures to ensure their 125 Plan, DCFSA and HCFSA plans pass nondiscrimination tests:
Cafeteria plans, including DCFSA and HCFSA components, offer valuable tax savings to employees. Employers must conduct nondiscrimination testing to prevent discrimination and maintain compliance. By ensuring fairness in plan participation, employers can retain tax advantages and provide benefits equitably to employees across income levels.
BAS can perform nondiscrimination testing for your cafeteria plan and/or FSAs. To find out more, contact your account manager or email solutions@basusa.com.
Benefit Allocation Systems (BAS) provides best-in class, online solutions for: Employee Benefits Enrollment; COBRA; Flexible Spending Accounts (FSAs); Health Reimbursement Accounts (HRAs); Leave of Absence Premium Billing (LOA); Affordable Care Act Record Keeping, Compliance & IRS Reporting (ACA); Group Insurance Premium Billing; Property & Casualty Premium Billing; and Payroll Integration.
MyEnroll360 can Integrate with any insurance carrier for enrollment eligibility management (e.g., Blue Cross, Blue Shield, Aetna, United Health Care, Kaiser, CIGNA and many others), and integrate with any payroll system for enrollment deduction management (e.g., Workday, ADP, Paylocity, PayCor, UKG, and many others).