Many employers hear “nondiscrimination testing” and assume it’s one thing. It isn’t.
Section 125 testing applies to cafeteria plans (pre-tax elections like premium-only plans and FSAs), while Section 105(h) testing applies to self-insured medical plans (including HRAs).
The goals are similar—don’t favor the top of the house—but the who, what, and consequences differ.
Section 125: Cafeteria Plan Testing
A Section 125 cafeteria plan must demonstrate that it doesn’t favor highly paid or key employees in three key areas:
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Eligibility – Who can participate?
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Contributions & Benefits – Are the terms richer for the highly paid?
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Key-Employee 25% Concentration – No more than 25% of the plan’s total nontaxable benefits can go to key employees.
Who counts as “highly compensated” under §125?
The law defines this group broadly. It includes:
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Officers
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<5% shareholders
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Anyone “highly compensated” under §414(q)
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Spouses or dependents of any of the above
(That last one often surprises employers.)
What happens if a §125 plan fails?
If a cafeteria plan discriminates, the highly compensated participants—not rank-and-file employees—lose the tax exclusion for their pre-tax elections that year.
Practically, those amounts become taxable wages for the affected group.
Quick note on terminology: You’ll hear vendors say “HCEs” for §125, but the code uses highly compensated participants/individuals and refers separately to key employees for the 25% test. It also cross-references §414(q) for the general HCE definition.
Section 105(h): Self-Insured Medical Plan Testing
Section 105(h) applies to self-insured medical plans, including HRAs. It has two tests:
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Eligibility Test – Enough non-highly-compensated individuals (HCIs) must be eligible.
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Benefits Test – The plan’s benefit design can’t favor HCIs (e.g., richer reimbursements or lower deductibles for execs).
Who counts as an HCI under §105(h)?
Different from §125. Here, an HCI is:
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One of the five highest-paid officers
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A >10% shareholder
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Among the highest-paid 25% of all employees (after excluding certain groups)
No spouse/dependent rule here.
What happens if a §105(h) plan fails?
If discriminatory, reimbursements to HCIs become taxable. The nondiscriminatory exclusion under §105(b) is lost for the “excess” portion. Treasury regs detail how to calculate the taxable amount.
💡 Reminder: §105(h) applies only to self-insured medical plans. Fully insured medical plans aren’t currently subject to §105(h) (the ACA’s nondiscrimination rule under PHS Act §2716 was proposed but enforcement has been delayed).
| Aspect | §125 (Cafeteria Plans) | §105(h) (Self-Insured Plans) |
|---|---|---|
| What’s tested? | Pre-tax elections and benefits under the cafeteria plan (premium-only plans, FSAs). | Eligibility and benefits under a self-insured medical plan (self-funded major medical, HRAs). |
| Who’s “highly compensated”? | Officers, >5% owners, §414(q) HCEs, and their spouses/dependents. | 5 highest-paid officers, >10% owners, or top 25% of employees. |
| Key employee test? | Yes — 25% concentration cap. | No. |
| Penalty if failed | HCEs’ cafeteria plan benefits become taxable. | HCIs’ reimbursements under the plan become taxable (excess reimbursement rules). |
| Fully insured plans covered? | Yes, for §125 elections. | Not currently enforced. |
Practical Tips for Employers
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Calendar your testing — Run mid-year and at year-end so you can fix issues before W-2s close.
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Confirm your testing population — Aggregated groups, officer lists, ownership changes, and excludable employees all matter.
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Watch benefit design — Don’t create an “executive HRA” or enhanced self-funded tier without testing its §105(h) impact.
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Keep documentation — Auditors and carriers may request workpapers during reviews.
Bottom Line
Sections 125 and 105(h) share a purpose: preventing benefit plans from tilting toward leadership.
But they apply to different plans, define “highly compensated” differently, and impose different tax consequences.
Employers can run these tests internally, but with controlled-group rules, ownership look-throughs, and overlapping definitions, most find it safer to outsource to a TPA or benefits compliance firm—and loop in legal counsel if self-funded or multi-entity.