What Is Deemed 125 Compensation for Retirement Plans?

Deemed 125 compensation is a narrow category defined in Treasury Regulation 1.415(c)-2(g)(6): it covers amounts excluded from an employee’s income under Section 106 for employer-provided health coverage that the employee could not have taken as cash for one reason only — the employee could not certify that they had other health coverage. A retirement plan may treat those amounts as compensation for Section 415 purposes, provided the plan applies the rule uniformly to every employee in the same situation.¹

The label matters because it is easy to confuse with the broader Section 125 add-back rule that most payroll and retirement systems already apply. They are related but distinct, and only one of them is truly “deemed.”

What Makes an Amount Deemed Rather Than Elected

A regular Section 125 salary reduction is an election. The employee signs an agreement before the plan year, chooses to redirect part of their gross pay toward health premiums, an FSA, or a similar qualified benefit, and gives up the cash they could otherwise have taken. That elected amount is excluded from taxable wages under Section 125(a).

Deemed 125 compensation looks different. The employee never had a real cash option. The employer’s arrangement provides health coverage automatically, and the only path to cash is proof of other coverage. When the employee cannot provide that certification, they keep the health coverage by default. The value of that coverage was excluded from income under Section 106, but the exclusion was not the product of a genuine cafeteria plan election. The regulation treats it as if it had been, but only for the specific purpose of letting a retirement plan count it as compensation.¹

Why a Plan Would Include These Amounts

Section 415(c) caps total annual additions to a defined contribution plan at the lesser of 100 percent of the participant’s compensation or, for 2026, $72,000.² The percentage side of that cap depends on how compensation is defined. If health coverage that the employee could not decline for cash is left out of the compensation figure, the employee’s contribution ceiling shrinks by the value of that coverage. Building deemed 125 amounts into the definition restores the full economic value of the pay package.

The regulation does not require a plan to include deemed 125 compensation. It permits inclusion, and it conditions that permission on uniform treatment: if the plan counts these amounts for one employee whose benefits fit the description, it must count them for every employee whose benefits fit the description.¹ Selective application is not allowed.

How This Sits Alongside the Broader Section 125 Add-Back

The broader add-back applies to genuine cafeteria plan elections. Section 415 compensation includes wages, salaries, and other amounts received for services, and it specifically includes amounts that would have been received and includible in gross income but for an election under section 125(a).¹ The statute is explicit: compensation includes any amount contributed or deferred by the employer at the employee’s election that is excluded from gross income because of Section 125.³

In practice this means an employee earning $100,000 who redirects $12,000 through a cafeteria plan into health premiums and an FSA has taxable wages of $88,000, but compensation for Section 415 purposes of $100,000. The contribution ceiling is calculated against the full $100,000. If the plan administrator used $88,000 instead, the employee’s limit would be artificially low, cutting off contributions too early in the year and potentially reducing employer matching dollars as well.

Deemed 125 compensation adds a further layer on top of this. Where the broader rule captures elected redirections, the deemed rule captures the employer-provided coverage the employee kept only because they could not certify to other coverage. A plan that wants to credit the full compensation package can pick up both, so long as it does so consistently.

Common Elements That Belong in the Elected Category

The elected category typically covers health, dental, and vision premiums paid through payroll deduction; contributions to a medical flexible spending account or dependent care assistance program; health savings account contributions routed through the employer’s plan; and adoption assistance offered through the cafeteria plan. The common thread is that every one of these dollars would have been taxable wages if the employee had taken cash instead. Employer contributions that were never offered as a cash alternative do not belong in this category. They may, depending on the facts, belong in the deemed category.

Other 2026 Figures That Depend on the Compensation Definition

The compensation figure a plan uses feeds into several other 2026 limits:

Elective deferral limit under Section 402(g): $24,500
Catch-up contribution for participants age 50 and older: $8,000
Enhanced catch-up for participants aged 60 through 63: $11,250
Annual compensation cap used for contribution calculations: $360,000
Highly compensated employee threshold (prior-year earnings): more than $160,000
Key employee threshold for top-heavy testing: more than $235,000

Each of these figures is applied to a compensation number.² Whether that number includes deemed 125 amounts changes who counts as highly compensated, who counts as a key employee, and how much room each participant has under the annual additions cap.

What Happens When a Plan Gets It Wrong

A compensation definition that leaves out amounts the plan document says to include (or includes amounts the document says to leave out) can produce excess annual additions, failed nondiscrimination tests, or both. The IRS Voluntary Correction Program lets plan sponsors fix these errors outside of an audit. For submissions made on or after January 1, 2026, the user fees are $2,000 for plans with $0 to $500,000 in assets, $3,500 for plans over $500,000 up to $10 million, and $4,000 for plans over $10 million.⁴

Those are the IRS user fees only. The full cost of a correction typically runs higher once counsel, actuaries, and administrator time are added. An error in the compensation definition that persists across multiple plan years compounds: each affected year may require its own testing corrections, contribution refunds, and amended filings. When a plan fails the ADP or ACP nondiscrimination tests and the employer misses the two-and-a-half-month correction window after the plan year ends, a 10 percent excise tax applies to the excess amounts.⁵

Two practical safeguards prevent most of these problems. The plan document should state clearly whether Section 415 compensation includes elected Section 125 amounts, deemed 125 amounts, or both. The payroll system should track each category separately from taxable wages so that the compensation figure the administrator uses ties back to a source that can be audited. Auditors check this data early, and configuration errors caught at the start of a plan year are far cheaper to fix than the same errors caught years later.

1
eCFR. 26 CFR 1.415(c)-2 – Compensation
2
Internal Revenue Service. 2026 Amounts Relating to Retirement Plans and IRAs, as Adjusted for Changes in Cost-of-Living
3
Office of the Law Revision Counsel. 26 USC 415 – Limitations on Benefits and Contribution Under Qualified Plans
4
Internal Revenue Service. Voluntary Correction Program (VCP) Fees
5
Internal Revenue Service. 401(k) Plan Fix-It Guide – The Plan Failed the 401(k) ADP and ACP Nondiscrimination Tests