This is the fifth article in our Compliance 101 blog series where we use six questions to break down important compliance topics. Below you will learn more about Section 125 Cafeteria Plan Nondiscrimination Testing (NDT). Read more below!
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Who is required to perform Section 125 cafeteria plan nondiscrimination testing (NDT)?
- All employers (public or private, including church plans not subject to ERISA, regardless of size or number of participants) who allow paycheck deductions for employer-provided health and welfare benefits on a pretax basis must do so through a Section 125 Cafeteria plan. That plan must have nondiscrimination testing done annually, as of the last day of the plan year. (If a cafeteria plan is not used, employees must be taxed on the cash they would have received even if the amounts are used to pay for qualified benefits.)
What is the purpose of Section 125 cafeteria plan nondiscrimination testing and the definition of employer?
- Nondiscrimination testing ensures the plan does not favor highly compensated and/or key employees.
- Highly compensated means any individual or participant who – for the prior plan year or the current plan year in the case of the first year of employment – had annual compensation from the employer more than the compensation amount specified in the Internal Revenue Code and, if elected by the employer, was also in the top-paid group of employees for the year. For 2020, the applicable compensation amount is $130,000 ($125,000 in 2019).
- Key employee is a participant who, at any time during the current plan year, is one of the following:
- An officer with annual compensation greater than an indexed amount of $185,000 for 2020 (indexed yearly).
- A more than five percent owner of the employer*.
- A more than one percent owner of the employer with compensation over $150,000*.
- *The definition of “employer” used for NDT = all members of a controlled group (as defined by IRS Code Section 414) are treated as a single employer for eligibility testing purposes. i.e. Employees from related employers are taken into account when testing a cafeteria plan offered by one employer within the controlled group.
Which nondiscrimination tests are Section 125 cafeteria plans subject to?
A cafeteria plan must pass the following three tests unless a safe harbor applies:
- Eligibility test—determines whether enough non-highly compensated participants are eligible to participate in the plan.
- Contributions and benefits test—determines whether the benefits are available to non-highly compensated participants and the proportion of non-highly compensated participants electing vs. highly compensated participants.
- Key Employee Concentration test—determines the total value of nontaxable benefits provided and whether key employees receive more than 25%.
Why does Section 125 cafeteria plan nondiscrimination testing matter?
- If audited by the IRS, an employer may need to furnish the testing results as well as any corrective action the employer took due to test failure.
- Failure to test may result in penalties e.g. loss of tax advantage to all participants.
- Failure may lead to taxation of specific employees and possible penalties if not corrected by the employer.
When is it best to run Section 125 cafeteria plan NDT?
- Section 125 requires testing to be performed on the last day of the plan year. However, ideally nondiscrimination tests would be run at the beginning, during and on the last day of the plan year which would allow employers to make adjustments before the end of the plan year, if it appears one or more of the tests may not pass. It is not permissible to make corrections after the end of the plan year and the prohibited group of the plan that fails will be adversely affected (i.e. tax consequences).
How are Section 125 cafeteria NDT failures corrected?
- If the plan fails the nondiscrimination tests, then highly compensated and key employee's excess reimbursements will be taxable. Excess reimbursements are includable in a highly compensated and key employee's income. The excess reimbursement calculation varies based on whether the benefits were paid to highly compensated and key employees due to either discriminatory coverage for failing to meet the eligibility test, or discriminatory benefits for failing to meet the benefits test.
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Disclaimer: This blog was written by Michelle Turner, MBA, CEBS, Compliance Consultant, Alera Group Central Region. This blog post intends to provide general information regarding the status of, and/or potential concerns related to, current employer HR & benefits issues. This blog should not be construed as, nor is it intended to provide, legal advice. The opinions expressed herein are based upon the author’s experience as a Compliance Consultant and may not reflect the opinions of your counsel.
The information contained herein should be understood to be general insurance brokerage information only and does not constitute advice for any particular situation or fact pattern and cannot be relied upon as such. Statements concerning financial, regulatory or legal matters are based on general observations as an insurance broker and may not be relied upon as financial, regulatory or legal advice. This document is owned by Alera Group, Inc., and its contents may not be reproduced, in whole or in part, without the written permission of Alera Group, Inc.
This article was last reviewed and up to date as of 09/03/2020.