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Section 125 Plans and Nondiscrimination Testing Rules: The Basics

February 27, 2024

IRS rules allow workers to take advantage of certain types of programs to save money on their group insurance premiums. One example that you are probably aware of is the Section 125 plan and its cousin, the Section 125 Premium Only Plan (POP). As a broker, you can improve your standing with clients by becoming an expert in these plans.

In this post, we are going to focus on Section 125 POP, with a special emphasis on the nondiscrimination testing rules associated with them. The rules were put in place to ensure that highly compensated employees (HCEs) do not benefit unfairly from the plans compared to non-highly compensated employees (NHCEs).

A Brief Overview

The Section 125 POP is a tax-advantaged plan offered under Section 125 of the IRS code. It is a plan that allows employees to pay all or a portion of their health insurance premiums through pre-tax payroll deductions. The ultimate goal is to help employees save money by reducing their tax burdens.

Employees can choose the amount they want to contribute to their POPs according to their needs and budgets. However, unlike a general Section 125 plan, money contributed to a POP can only cover health insurance premiums. The plans themselves are not insurance plans.

Nondiscrimination Testing Rules

Section 125 POPs are designed to help middle class workers cover their group insurance premiums more efficiently while putting more money in their pockets. To prevent the plans from becoming tax loopholes for HCEs, the IRS instituted a series of tests. There are four such tests. They are required annually, and failing to pass them could mean financial penalties for both employers and affected HCEs.

The tests are divided into three categories:

1. Coverage

There are two coverage tests, known as the 70% Test and the 80/70 Test. The first test dictates that a minimum of 70% of all "non-excludable" employees participate in the plan. Certain categories of employees are exempted from the test, including part-time workers.

The 80/70 Test dictates that at least 80% of the plan enrollees qualify as NHCEs. Furthermore, at least 70% of all non-excludable employees must be eligible to participate in the plan.

Note that there are HCE testing exceptions for employers when HCEs are excluded from participation because of company entity. For example, shareholders of 2% or more in an S Corp, members of a LLC, partners in a partnership, and sole proprietors cannot participate in a POP-only plan.

2. Average Benefit

The Average Benefit Test (ABT) compares the average pre-tax benefits of both participating HCEs and NHCEs. Average HCE benefits cannot exceed their NHCE counterparts by more than 25%. (This rule only applies to C Corp companies.)

3. Implausible Compensation

The Implausible Compensation Test looks at the total compensation HCEs receive. It ensures that HCEs are not gaining access to the POP by artificially reducing their compensation.

The POP Safe Harbor Test

Employers who may have trouble with any of the tests, or just prefer a 'shortcut' so to speak, can rely on the POP Safe Harbor test to demonstrate their plans are in compliance. A plan that passes the Safe Harbor test is assumed to have also passed the other tests as well.

The POP Safe Harbor test is based on the ratio between the number of participating NHCEs and HCEs, and must be at least 50%. Calculating the ratio is fairly easy. You calculate the percentage of each group that takes part in the POP, then you divide the NHCE number by the HCE number. However, the test is subject to three qualifying questions. Employers must answer 'yes' to all three in order to pass safe harbor testing:

1. Premium-Only Plan Condition: Is the only benefit an employee can choose under the Section 125 Plan an election to deduct wages pretax for the payment of the employee share of the employer provided accident and/or health insurance premium, including group health, dental and vision?

2. Eligibility Condition: Excluding HCEs, were at least 50% of regular employees (full- and part-time) who received a W-2 eligible to participate in the plan?

3. Same Plan Benefits Condition: Are the same plan benefits and benefit options that are available to HCEs also available to non-HCEs?

Working With a General Agency to Offer POPs

Section 125 POPs are complex plans governed by strict rules. For this reason, we recommend that brokers work with general agencies like BenefitMall equipped to help them both offer and manage the plans in accordance with IRS rules. Section 125 plans are required for all employers deducting insurance premiums on a pre-tax basis. Likewise, those employers must conduct and pass the nondiscrimination testing rules.

Any clients you have already set up will still need a Section 125 POP if they want to offer employees a way to contribute to health insurance with pre-tax dollars. In addition, those plans will need to be tested annually to make sure they maintain compliance. Working with a general agency who can support you with guidance, documentation, and direct assistance can make all the difference in the world.

If you are not familiar with Section 125 plans, we encourage you to reach out to your general agency to learn more. They are a fantastic value-adding product with the potential to significantly boost your book of business.

For more information or to request an application, contact BenefitMall today.

Patti Reimer
Sales Executive, Value Added Products
Email: Patti.Reimer@benefitmall.com