A Guide to Non-Discrimination Rules and Testing for Fully Insured Group Health Plans

A Guide to Non-Discrimination Testing for Fully Insured Group Health Plans

Most employer group benefit plans provide tax-advantaged benefits and are subject to non-discrimination rules to discourage employers from providing more generous benefits to Highly Compensated Individuals (HCIs) and/or Key Employees.

The employer sponsored benefit plan may fail one or more non-discrimination tests if plan structure includes any of the provisions (listed below) that favor executive staff, management staff, or other high paid employees.

• Lower contributions
• Availability of more benefits
• Higher level of benefit reimbursement
• Shorter waiting period
• Benefit limits that vary based on age, years of service or compensation

Fully Insured group health plans currently do not have to follow the exact same non-discrimination rules as Self-Funded group health plans. But most plans do include cafeteria plan (Section 125) pre-tax health plan contributions. Under Section 125 guidelines, there are non-discrimination rules that must be followed as required by IRS regulations.

Under the IRC (Internal Revenue Code) §125, or sometimes called cafeteria plans, the plan cannot discriminate in favor of Highly Compensated Individuals (HCI) and Key Employees. Plans that fall under these guidelines are pre-tax FSAs, HSAs, and health plan contributions towards benefit premiums.

What is a Section 125 Plan?

A Section 125 Plan is the means by which an employer can offer employees a choice between taxable and nontaxable benefits. A plan offering only a choice between taxable benefits is not a Section 125 plan.

Who is not eligible for a Section 125 Plan?

1. Self-employed individuals
2. Partners in a partnership
3. Those who own more than 2% of a subchapter S corporation

Examples of Qualified Benefits Under a Section 125 Plan

1. Group health plan coverage
2. Dental & Vision benefits
3. Health FSA
4. DCAP (Dependent Care FSA)
5. Health Savings Account (HSAs) contributions
6. Life Insurance
7. Disability Benefits
8. Adoption Assistance

To Receive Federal Tax Advantage for a Section 125 Plan, the plan must comply with the following.

1. Must have a written plan document
2. Only common-law employees may participate on a pre-tax basis (according to the IRS, a common-law employee is defined as an employee whose employer has the right to control the work they do and how that work is done).
3. Elections cannot generally be changed for the entire plan year (unless certain conditions are met and the change in enrollment is consistent with the event)
4. Must pass certain non-discrimination tests

The following non-discrimination tests apply:

1. Eligibility Test
2. Contributions & Benefits Test
3. Key Concentration Test

Eligibility Test

This test looks at whether a sufficient number of non-highly compensated employees are eligible to participate in the cafeteria plan. If too many non-highly compensated employees are ineligible to participate, the plan will fail this discrimination test.

The plan must benefit a group of employees under ‘valid’ classifications.

Examples of classifications may be:

• Salaried vs hourly
• Geographic location
• Other bona fide business criteria

The plan must have a sufficient ratio of non-Highly Classified Individuals (HCIs) that must be eligible to participate.

Highly Compensated Individuals are classified as:

• Officers of the company
• More than 5% owners
• Highly compensated (IRS defines this as an individual that earned more than $130,000 in 2021 for 2022 testing: earned more than $135,000 in 2022 for 2023 testing: or earned more than $150,000 in 2023 for 2024 testing)
• A spouse or dependent of one of the above

Benefits & Contributions Test

This test is designed to make sure that a plan’s contributions and benefits are available on a non-discriminatory basis and that highly compensated employees do not select more nontaxable benefits than non-highly compensated employees select.

Non-Highly Compensated Individuals cannot be charged more than a similarly situated highly compensated individual for the same benefit.

Benefits and contributions must be available on a ‘nondiscriminatory basis’.

Key Employees Concentration Test

This test looks at whether Key Employees impermissibly utilize the plan’s benefits more than non-Key Employees. Under this test, Key Employees must not receive more than 25% of the aggregate nontaxable benefits provided to all employees.

All cafeteria plans are included in this test, including FSA elections and HSA contributions.

Key Employees are determined based on the preceding plan year and are defined as follows.

1. Officers with compensation over $200,000 in 2022 for 2023 testing or $215,000 in 2023 for 2024 testing.
2. More than 5% owners; and
3. More than 1% owners with compensation over $150,000 (not indexed).

If the plan fails any test, HCIs and/or Key pre-tax elections must be treated as taxable income.

Potential ways to satisfy the above rules

For contribution or benefit differences based on factors other than geographic market differences, maintain separate cafeteria plans for employee groups based on:

• Division
• Business Unit, and
• Profit center or similar distinction
• If HCIs have lower contributions, deduct them on an after-tax basis
• Do not charge HCIs or Key Employees for coverage (exclude them from cafeteria plan participation), however, this tactic will fail under the §105(h) tests if the group benefits are self-insured.  

What about Dependent Care Assistance/FSA Plans?

The Dependent Care FSA non-discrimination rules are part of the IRC §129 tests.

Two tests apply to this section of the code.

1. More than 5% Owners Contribution Test - no more than 25% of the benefits may be provided to more than 5% owners (or family members).
2. 55% Average Benefits Test – the average benefit for non-highly compensated employees must be at least 55% of the average benefit for the Highly Compensated Individuals (HCIs).

For #2 above, HCIs are defined as:

• More than 5% owners during the current or preceding year; or
• Highly compensated in the preceding year (earning more than $135,000 in 2022 for 2023 testing and $150,000 in 2023 for 2024 testing)

If the plan fails any of the tests above, the HCI dependent care benefits are treated as taxable income.

Potential ways to satisfy the above rules:

1. Always test earlier in the plan year once elections have been made and adjust owner and HCI elections as necessary.
2. Limit owner and HCI elections to a reduced amount to improve testing results.
3. If the employer is a small employer, do not permit owners and HCIs to participate in the dependent care FSA.  

A few FAQs on non-discrimination testing and Fully Insured Plans

Q. What are the non-discrimination rules for fully insured plans?

A. For a plan to be considered non-discriminatory with respect to eligibility, the plan must pass one of two numerical “coverage” tests. The two tests are:

• 70% of all employees are covered under the plan; or
• The plan covers at least 80% of eligible employees and 70% of all employees are eligible for coverage.

Q. What plans are subject to non-discrimination testing & Is non-discrimination testing required?

A. Non-discrimination testing is required for employers who offer plans governed by Section 125 of the Internal Revenue (IRS) code. The plans are:

• Health Savings FSA plans
• Dependent Care FSA plans
• Health Reimbursement Arrangements (HRA)
• Health Savings Accounts (HSA)

Q. Are fully insured plans subject to non-discrimination testing?

A. The Section 105(h) non-discrimination rules do not apply to fully insured group health plans. However, under the Affordable Care Act (ACA), nondiscrimination rules that are similar to the Section 105(h) rules are expected to apply to non-grandfathered fully insured plans in the future.

Q. What is included in non-discrimination testing?

A. Non-discrimination testing should be performed by the last day of the current plan year and include all employees who were employed on any day during the plan year. It is also recommended that employers test once early or in the middle of the plan year in order to be able to make the appropriate adjustments in the event the plan fails during any of the tests’ criteria.

While every effort has been taken in compiling this information to ensure that its contents are totally accurate, neither the publisher nor the author can accept liability for any inaccuracies or changed circumstances of any information herein or for the consequences of any reliance placed upon it. This publication is distributed on the understanding that the publisher is not engaged in rendering legal, accounting, or other professional advice or services. Readers should always seek professional advice before entering into any commitments.