Section 125 Nondiscrimination Testing: 2026 Employer Guide

Section 125 nondiscrimination testing is the annual compliance step that protects the tax savings in a cafeteria plan. The IRS allows employees to pay for benefits with pre-tax dollars only if the plan treats lower-paid workers fairly compared to owners and executives. This guide explains the three tests, who counts as highly compensated, when testing happens, and what a failed test costs.

If you are new to cafeteria plans, start with our Section 125 cafeteria plan 2026 guide for the basics, then come back here for the testing rules.

What is Section 125 nondiscrimination testing?

Section 125 nondiscrimination testing is a set of IRS-required calculations that check whether a cafeteria plan favors highly compensated or key employees. The IRS requires the test because pre-tax benefits reduce federal income tax and FICA, and the government does not want that tax break to flow mostly to owners and executives. The test compares how much value highly compensated employees get from the plan against how much value everyone else gets.

A cafeteria plan is the only way employees can pay for benefits with pre-tax dollars under Internal Revenue Code Section 125 (IRS). Without a compliant plan, every premium dollar is taxed. Nondiscrimination testing is the price of admission for that tax treatment. The IRS spells out the rules in Section 125(b), (c), and (g), and in the proposed cafeteria plan regulations.

Testing applies to the plan as a whole and to specific benefits inside it. A premium only plan, a flexible spending account (FSA), and a dependent care account each have their own test rules. Most small and mid-size employers run all required tests at once through their plan administrator.

What are the three Section 125 nondiscrimination tests?

A standard cafeteria plan must pass three tests: the eligibility test, the contributions and benefits test, and the key employee concentration test. Each test looks at a different way a plan could tilt toward the top of the pay scale. A plan must pass all three to keep pre-tax treatment for highly compensated and key employees.

Here is what each test measures.

The 25% key employee rule is the one that trips up small businesses most often. In a 12-person company where the two owners and a spouse run most of their benefits through the plan, the owners can easily cross the 25% line. That is a math problem, not a paperwork problem, and it has to be solved during plan design.

Who counts as a highly compensated or key employee?

A highly compensated employee for cafeteria plan purposes is an officer, a more-than-5% owner, an employee earning above the IRS compensation threshold, or a spouse or dependent of any of those people. A key employee is generally an officer earning above a set dollar amount, a more-than-5% owner, or a more-than-1% owner earning above $150,000 (IRS). The exact dollar thresholds adjust most years, so confirm the current figures with the IRS or your plan administrator before testing.

These definitions matter because the tests compare this group against everyone else. The more compensation and ownership concentrate at the top, the harder the tests are to pass. A company with one owner and 40 employees on similar pay usually passes with room to spare. A company with three owners and six staff has to design the plan carefully.

2026 thresholds for Section 125 testing

For 2026 testing, the IRS dollar thresholds are set by IRS Notice 2025-67.

Two details catch owners off guard. Ownership is attributed within a family, so an owner's spouse, children and parents are generally treated as owning the same shares, and a spouse who works in the business can be a key employee on paper. And more-than-2% shareholders of an S corporation cannot participate in a cafeteria plan at all, as explained in our guide to Section 125 plans for S corp shareholders. For the full definitions, see the highly compensated employee threshold and the key employee definition.

How do you run Section 125 nondiscrimination testing?

You run Section 125 nondiscrimination testing by building an employee census, flagging who is highly compensated or key, and running the three tests against that census. Under the IRS proposed regulations, testing is done as of the last day of the plan year and includes every employee who worked on any day of the year, including people who left.

1. Pull the census. For every employee who worked any day in the plan year: hire date, termination date, date of birth, hours or full-time status, compensation for this year and last year, ownership percentage, officer status, and family relationships to owners.
2. Apply your exclusions. Some groups can be left out, such as union employees covered by a collective bargaining agreement and newer employees who have not met your plan's service requirement. Which exclusions apply depends on the test and on your plan document.
3. Flag highly compensated and key employees using the 2026 table above.
4. Add up qualified benefits for each person: pre-tax premiums, health FSA and dependent care elections, pre-tax HSA contributions, and any employer flex credits run through the plan.
5. Run the three calculations below and keep the results with your plan records.

The formulas most administrators use:

• Eligibility test: percentage of non-highly compensated employees who are eligible, divided by the percentage of highly compensated employees who are eligible. If everyone is eligible, the ratio is 100% and the plan passes. Plans that exclude a job class compare the ratio to the IRS safe harbor percentage in Treasury Regulation 1.410(b)-4, which starts at 50%. The plan also cannot require more than three years of employment to join.
• Contributions and benefits test: qualified benefits of highly compensated employees as a percentage of their pay, compared with the same percentage for everyone else. If the highly compensated percentage is higher, the plan is at risk.
• Key employee concentration test: qualified benefits of key employees divided by qualified benefits of all employees. The result must be 25% or less under Section 125(b)(2).

Worked example: a 10-person company where the owner is the CEO

This example is a disclosed hypothetical. A C corporation has 10 employees. The owner is the CEO and owns 100% of the company. The owner's spouse works as the office manager. The other 8 employees earn about $48,000 each, and everyone is eligible after 30 days.

• Eligibility test: everyone is eligible, so the ratio is 100%. Pass.
• Key employee concentration test: key employees receive $21,400 of $34,400, or 62%. The limit is 25%. Fail.
• Contributions and benefits test: even counting only the owner, $18,000 on $250,000 of pay is 7.2%, while the staff's $13,000 on $384,000 of pay is 3.4%. At risk.

The common fix here is for the owner to pay the family premium after tax. Key employee benefits then drop to $3,400 of $16,400, about 21%, and the plan passes for everyone else. Raising staff participation alone rarely works: the staff would need to elect more than $64,000 a year to bring the owners under 25%.

When do you run nondiscrimination testing?

Cafeteria plan nondiscrimination testing is performed for each plan year, and the IRS expects the test to reflect the plan's actual operation during that year. Most employers run a projection test before the plan year begins, then a final test as of the last day of the plan year. The IRS does not require you to file the test results, but you must keep them on hand in case of an audit.

Running an early test matters. If you wait until year-end and discover a failure, the affected highly compensated employees owe tax on benefits they already elected, and you cannot undo a plan year that already happened. A projection test in the first month gives you time to adjust the plan design, change contribution structures, or expand eligibility before the failure becomes real.

For more on how the underlying FICA savings work, see our guide to maximizing FICA tax savings.

What happens if a Section 125 plan fails the test?

If a cafeteria plan fails nondiscrimination testing, the highly compensated or key employees lose pre-tax treatment for the plan year, and their elected benefit amounts become taxable income. The rank-and-file employees keep their pre-tax treatment in full. The penalty falls only on the favored group the test is designed to protect against, not on the whole workforce.

For a failed key employee test, the key employees must include the value of their nontaxable benefits in gross income for the plan year. That means back federal income tax and, in most cases, the loss of the FICA savings on those amounts. The employer also has to correct payroll records and issue updated W-2 figures for the affected people.

A failed test does not shut down the plan. It does not make benefits taxable for regular employees. It is a targeted correction, and a well-designed plan with annual testing almost never reaches that point.

How do employers avoid a failed test?

Employers avoid failed tests by designing the plan around their real payroll and ownership data before the year starts. The most common fixes are broadening eligibility so more lower-paid employees can join, adjusting how owner and executive benefits run through the plan, and using a safe plan structure that limits key employee concentration. A premium only plan, where employees simply pay their share of insurance premiums pre-tax, has simpler testing than a full FSA-based plan.

Three practical steps lower your risk:

1. Run a projection test in the first month of the plan year using current payroll.
2. Keep eligibility broad so non-highly-compensated employees can participate.
3. Review owner and family member elections, since these drive the 25% key employee calculation.

Small employers with concentrated ownership benefit most from professional plan design. The savings from a Section 125 plan are real, but only if the plan passes its tests. Our guide to why Section 125 reduces W-2 wages shows how the pre-tax mechanics work once the plan is compliant.

Employers with 100 or fewer employees can also use a simple cafeteria plan, which is treated as passing the Section 125 tests in exchange for a required employer contribution. Our simple cafeteria plan safe harbor guide shows when that trade makes sense. Dependent care accounts carry their own extra tests, covered in our dependent care FSA testing guide.

Can you offer different benefits to managers and hourly staff?

You can treat employee classes differently only if the difference does not favor highly compensated employees. The regulations allow reasonable differences between similarly situated groups, such as employees in different locations. A richer employer contribution for managers than for hourly staff in the same plan option usually fails the contributions and benefits test when most managers are highly compensated. The safer route is to keep the same benefit menu and employer contribution for everyone and handle manager pay through salary.

Should you run testing yourself or use a plan administrator?

You can run nondiscrimination testing yourself if you have a clean census, understand family ownership attribution, and have time to rerun the numbers mid-year. Some benefit vendors sell self-service testing tools, and others run the tests for you, either bundled into plan administration or for an added fee.

For most small and mid-size employers, the hard part is not the arithmetic. It is knowing who counts as key, catching a failure while it can still be fixed, and changing the plan design without breaking something else. Summit Health Benefits sets up and administers Section 125 cafeteria plans with the written plan document, the summary plan description and nondiscrimination testing support included, and reviews your ownership and payroll structure before the plan year starts. If you want to see what a plan is worth first, estimate your payroll tax savings.

Frequently Asked Questions

Summit Health Benefits sets up compliant Section 125 plans with annual nondiscrimination testing included, so you keep your tax savings without the audit risk.

Sources

Internal Revenue Code Section 125(b), (c), and (g) and the IRS proposed cafeteria plan regulations (Internal Revenue Service); IRS rules on highly compensated and key employee definitions (Internal Revenue Service); IRS Notice 2025-67 (2026 highly compensated and key employee thresholds); Treasury Regulation 1.410(b)-4 (nondiscriminatory classification test). The 10-person example is a disclosed hypothetical for illustration.