Section 125 Cafeteria Plan Nondiscrimination Testing Rules

Section 125 cafeteria plan nondiscrimination testing is the annual check the IRS requires to confirm your plan isn’t steering most of the pre-tax benefit to owners, officers, and top earners. Every cafeteria plan must pass three core tests each year: an eligibility test, a contributions and benefits test, and a key employee concentration test.¹ Plans that offer dependent care assistance or health FSAs run through additional testing under Sections 129 and 105(h). When a test fails, the tax consequences fall only on the highly compensated participants or key employees who benefited from the imbalance — their pre-tax elections get reclassified as taxable wages for that plan year.

Who the Tests Are Checking On

Two separate categories drive the testing, and they aren’t interchangeable.

A highly compensated participant under Section 125(e) is an officer, a more-than-5% owner of the employer’s voting power or value, a highly compensated employee, or a spouse or dependent of any of those.² The compensation threshold for “highly compensated” is $160,000 for the 2026 plan year and adjusts with inflation.³

A key employee is defined under Section 416(i)(1) and centers on ownership and control. You’re a key employee if you’re an officer earning more than $235,000 in 2026, a 5% owner, or a 1% owner earning more than $150,000.⁴⁵ The officer threshold is inflation-adjusted; the $150,000 floor for 1% owners is a fixed statutory amount.

You’ll almost always have overlap between the two groups, but they get measured separately under different tests. Confusing them is one of the most common errors in plan administration.

The Eligibility Test

The eligibility test asks whether enough non-highly-compensated employees are allowed to participate, or whether the plan’s design quietly walls them out. If the eligible group isn’t a fair cross-section of the workforce, the plan fails at the door.¹

To pass the safe harbor, the eligible group must satisfy the classification rules of Section 410(b), which generally means it benefits a sufficient percentage of non-highly-compensated employees relative to highly compensated employees.⁶ The plan can’t require more than three consecutive years of employment before eligibility, and the service requirement has to be the same for everyone. Once an employee meets the requirement, participation must begin no later than the first day of the next plan year.⁷

Where plans typically get into trouble is excluding categories that sound neutral but effectively screen out lower-paid staff — salaried-only eligibility, or full-time status defined at an unusually high hour count. The IRS looks at results, not intentions.

The Contributions and Benefits Test

Getting employees in the door isn’t enough. This test checks whether participants have a real, equal shot at the same benefits and employer contributions, in availability and in actual use.¹ Two things get evaluated: benefit availability (can everyone choose the same options?) and benefit utilization (are highly compensated participants actually consuming a disproportionate share of the tax-free benefits?).⁸

Utilization becomes disproportionate when qualified benefits elected by highly compensated participants, measured as a percentage of their total compensation, exceed the same ratio for everyone else. This is where neutral-looking designs produce discriminatory results. Offer a rich health option next to a bare-bones one, and if executives overwhelmingly pick the rich one while lower-paid employees can’t afford it, the math turns against the plan even though the menu was technically the same for both.

A safe harbor exists for health benefits. The test is satisfied if the employer contributes, for each participant, at least 100% of the cost of coverage chosen by the majority of similarly situated highly compensated participants, or at least 75% of the cost of the highest-cost coverage option available to any similarly situated participant. Contributions above that must bear a uniform relationship to each participant’s compensation.⁶ Testing is performed as of the last day of the plan year and takes into account everyone who was an employee at any point during the year.⁸

The Key Employee Concentration Test

This one runs independently of the other two. It looks at the total dollar value of tax-free benefits flowing to key employees as a group and caps that at 25% of the tax-free benefits provided to all employees under the plan.¹ Rank-and-file employees must receive at least 75% of the plan’s aggregate tax-free value.

The concentration test is harder to control than it sounds, especially at smaller companies where a few owners make up a meaningful share of headcount. If three partners at a 20-person firm each max out their health FSA and dependent care FSA while most other employees barely use the plan, the key employee share can push past 25% fast. Employers should track these totals throughout the year rather than discover the problem in January.

Extra Testing for Dependent Care and Health FSAs

If your plan offers dependent care assistance or a health FSA, there are additional nondiscrimination rules that can catch what the Section 125 tests miss.

Dependent Care Assistance Under Section 129

Two thresholds matter most. No more than 25% of the dependent care benefits paid during the year can go to more-than-5% owners. And the average benefit received by non-highly-compensated employees must be at least 55% of the average benefit received by highly compensated employees. Fail either, and highly compensated employees lose their pre-tax treatment on dependent care for the year.

Usage patterns drive this. Higher-earning employees are more likely to have significant childcare expenses and elect the full $5,000 dependent care FSA, while lower-paid staff may skip it entirely. That lopsided participation can push the 55% test into failure territory even when the plan is open to everyone.

Health FSAs Under Section 105(h)

A health FSA offered through a cafeteria plan is treated as a self-insured medical reimbursement plan and must also pass the nondiscrimination rules of Section 105(h). Those rules have their own eligibility test (the plan can’t favor highly compensated individuals in who can participate) and a benefits test (the plan can’t provide higher reimbursements to highly compensated individuals). A health FSA that passes Section 125 can still fail Section 105(h), so both sets of testing need to run.

What Happens When a Test Fails

When a cafeteria plan fails any required test, the penalty is targeted. The pre-tax benefits received during that plan year by highly compensated participants or key employees get reclassified as taxable income.¹ The statute is specific: the Section 125(a) exclusion from gross income simply doesn’t apply to those individuals when the plan is discriminatory. The benefits are treated as received in the taxable year the plan year ends.

In practice, the salary reduction amounts those employees contributed get added back to their taxable wages, subject to federal income tax, Social Security, and Medicare. The employer typically issues corrected W-2s and owes its share of the additional payroll taxes. Rank-and-file employees are unaffected and keep their pre-tax treatment. Only the people who received the disproportionate benefit bear the cost.

Fixing a Failure and Why Timing Matters

The window for correcting a failed nondiscrimination test is narrower than most employers realize. If you catch the problem during the plan year, you can amend the plan prospectively — either reduce the benefits or contributions available to highly compensated employees, or increase what’s available to everyone else.⁹ Any mid-year election changes made as part of the correction have to comply with the change-in-status rules under the cafeteria plan regulations.

Once the plan year is over, retroactive correction is off the table. The IRS has stated that no provision in the Code or regulations allows a cafeteria plan to fix a nondiscrimination failure by retroactively adjusting benefits or contributions after the plan year ends.⁹ Unlike qualified retirement plans, which have formal correction programs such as EPCRS, cafeteria plans have no equivalent after-the-fact fix. Miss the plan year close and the tax consequences for highly compensated participants and key employees are locked in.

Running the tests mid-year, ideally around the six-month mark, gives you time to adjust contribution levels or expand participation before the numbers harden. Waiting until the annual testing deadline to find a failure guarantees corrected W-2s instead of a fixed plan.

The Simple Cafeteria Plan Safe Harbor

Small employers can skip the full testing process by adopting a simple cafeteria plan under Section 125(j). A plan that meets the requirements is automatically treated as satisfying the nondiscrimination rules.¹⁰

To qualify, the employer must have averaged 100 or fewer employees during either of the two preceding years. A business that grows past that mark keeps the safe harbor as long as headcount stays at or below 200.¹⁰ All employees with at least 1,000 hours of service in the preceding plan year must be eligible, though the plan may exclude employees under age 21, those with less than one year of service, collectively bargained employees, and nonresident aliens with no U.S.-source income.

The employer must contribute for every eligible non-highly-compensated, non-key employee under one of two formulas: a uniform percentage of pay of at least 2%, or a match equal to the lesser of 6% of compensation or twice the employee’s salary reduction. Under the matching option, the match rate for highly compensated and key employees can’t exceed the rate available to other employees. The employer contribution is owed whether or not the employee makes a salary reduction election. That’s the trade — guaranteed employer money in exchange for bypassing nondiscrimination testing altogether.

1
Office of the Law Revision Counsel. 26 USC 125 – Cafeteria Plans – Section: Exception for Highly Compensated Participants and Key Employees
2
Office of the Law Revision Counsel. 26 USC 125 – Cafeteria Plans – Section: Highly Compensated Participant and Individual Defined
3
Internal Revenue Service. COLA Increases for Dollar Limitations on Benefits and Contributions
4
Office of the Law Revision Counsel. 26 USC 416 – Special Rules for Top-Heavy Plans – Section: Definitions
5
Internal Revenue Service. Notice 2025-67: 2026 Amounts Relating to Retirement Plans and IRAs
6
Office of the Law Revision Counsel. 26 USC 125 – Cafeteria Plans – Section: Special Rules
7
Office of the Law Revision Counsel. 26 USC 125 – Cafeteria Plans
8
Federal Register. Employee Benefits – Cafeteria Plans
9
Internal Revenue Service. Chief Counsel Advice 201413006
10
Office of the Law Revision Counsel. 26 USC 125 – Cafeteria Plans – Section: Simple Cafeteria Plans for Small Businesses