Section 125 Nondiscrimination Tests
| Test | What It Measures | Consequence of Failure |
|---|---|---|
| Eligibility test | Whether the plan benefits a nondiscriminatory class of employees | HCEs lose pre-tax status |
| Contributions and benefits test | Whether HCEs receive disproportionately higher benefits | HCEs lose pre-tax status |
| Key employee concentration test | Whether key employees receive more than 25% of total benefits | Key employees lose pre-tax status |
HCE and Key Employee Definitions
Highly compensated employees (HCEs) for Section 125 purposes are: (1) officers; (2) shareholders owning more than 5% of the employer; (3) employees who are highly compensated; and (4) spouses or dependents of the above. Key employees are: (1) officers with compensation over $220,000 (2026); (2) 5% owners; and (3) 1% owners with compensation over $150,000.
Corrective Actions
Pro Tip
If nondiscrimination testing reveals a potential failure, corrective actions include: (1) reducing HCE elections to bring the plan into compliance; (2) increasing non-HCE participation through education and outreach; and (3) restructuring the plan to reduce the disparity between HCE and non-HCE benefits. Perform nondiscrimination testing early in the plan year to allow time for corrective action before year-end.