Is Non-Discrimination Testing on Your Premium-Only Plan Worth the Money?

Published by John Dalmata on May 17, 2019

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A Section 125 plan, AKA a cafeteria plan, allows employers to give employees the option of taking cash or make a pre-tax contribution to their employer-sponsored health plan. This is a great benefit to employers (reduced payroll and FICA tax) and employees (reduced taxable income and paying health premiums with pre-tax dollars).

While cafeteria plans have been around for decades, we still run into employers who deliver their plans on a post-tax contribution basis and miss out on the savings for their business and employees. A simple $300 plan document can save thousands of dollars year-over-year.

But that aside, there are stipulations to gaining the tax benefits of a Section 125 plan, and the IRS imposes strict testing to make sure that an employer’s plan does not discriminate in favor of highly compensated employees.

There are three non-discrimination tests to satisfy for an employer to attain Section 125 tax benefits:

The eligibility test: this test looks at whether a sufficient number of non-highly compensated individuals are eligible to participate in the cafeteria plan.
The benefits and contribution test: makes sure that the plan’s contributions and benefits are available on a non-discriminatory basis and that highly compensated participants do not select more nontaxable benefits than non-highly compensated participants select.
The key employee concentration test: this tests determines that key employee contributions do not exceed 25% of the total contributions into the plan

For Premium-only Plans (POP), the IRS provides a safe-harbor clause that reduces non-discrimination testing down to the eligibility test only (the plan will automatically satisfy the contributions and benefits test and the key employee concentration test if it passes the eligibility test).

While it’s not wrong to outsource your non-discrimination testing for your POP (some payroll companies charge $45/month for this), it may not be worth the investment—the eligibility test is fairly easy to perform in house.

In order to satisfy the eligibility test for your POP, the ratio of non-highly compensated participants to highly-compensated participants must be 50% or greater. Here’s the formula:

Say you had 100 non-highly compensated employees, of which 65 enrolled in your POP.

65/100= 65% participation of non-highly compensated employees

Then you had 25 highly-compensated employees, of which 20 participated in your POP.

20/25= 80% participation of highly compensated employees

Take your (non-highly compensated participation)/(highly compensated participation) to get your ratio for testing.

FINAL ANSWER: 65%/80% = 81%

In this case, since the ratio is above 50%, this example plan would pass the eligibility test, and in turn satisfy all other non-discrimination tests and be eligible for Section 125 tax incentives.