There's a quiet compliance risk sitting inside thousands of employer benefit plans right now, and most HR professionals and benefit brokers don't realize it until the IRS or the Department of Labor is already asking questions.
It's called nondiscrimination testing, and if you sponsor a Section 125 cafeteria plan, a Premium Only Plan (POP), or a self-funded medical plan under Section 105(h), you are required to run it annually. The stakes are significant: failed tests can strip the tax-favored status of benefits for highly compensated and key employees, triggering back FICA, income tax withholding, and potential audit exposure for the employer.
Here's the uncomfortable truth: in a year where the DOL has renewed its focus on ERISA audit quality and benefit plan compliance, and where 30% of audits sampled in recent DOL studies had at least one deficiency, simply hoping your plan passes the test is not a compliance strategy.
That's exactly why we're hosting a free, CE/SHRM-certified webinar on June 23, 2026: Discrimination testing demystified: ERISA, Section 125 & POP compliance simplified. But before that session, let's go deep on what you actually need to understand.
The real cost of getting discrimination testing wrong
When benefit professionals hear "nondiscrimination testing," many assume it's a retirement plan issue , something for the 401(k) team to worry about. That assumption is costing employers money.
Health and welfare benefit plans, including the cafeteria plans and self-funded medical arrangements that millions of American workers depend on, carry their own nondiscrimination obligations under the Internal Revenue Code. And unlike retirement plan testing, there's often no clean corrective distribution mechanism available once a plan year has closed. When a self-funded medical plan fails Section 105(h) testing, for example, there is no corrective action after the fact. The discriminatory benefits simply become taxable income to the highly compensated individuals (HCIs) affected.
For employers with meaningful populations of highly compensated or key employees, executives, officers, and high-earning professionals, a failed test can create significant and retroactive tax exposure. For the benefit brokers and consultants who advise them, it represents a client relationship at risk.
Section 125 cafeteria plans: The three tests you must pass
A Section 125 cafeteria plan allows employees to choose between cash and certain qualified benefits, health insurance premiums, FSAs, HSAs, dependent care accounts, on a pre-tax basis. That pre-tax treatment is the entire value of the plan for both employer (FICA savings) and employee (take-home pay). And it is entirely contingent on the plan passing three annual nondiscrimination tests.
1. The eligibility test
This test examines whether the plan discriminates in favor of highly compensated individuals (HCIs) in terms of who is eligible to participate. To pass automatically, the plan should be available to all employees under consistent eligibility criteria, same waiting period, same premium structure, same plan access, for every employee class. A plan that offers executives faster access or broader eligibility will fail here.
2. The contributions and benefits test
Even if everyone is technically eligible, the plan cannot discriminate in contributions or benefits in favor of HCIs. For 2026, an HCI is generally an employee who earned more than $160,000 in the prior year, or who is among the top 25% of earners. Officers with prior-year compensation exceeding $230,000 are also included. The test compares the ratio of benefit dollars to compensation between HCI and non-HCI groups, and that ratio cannot favor the top tier.
3. The key employee concentration test
This test ensures that "key employees", generally officers above the compensation threshold, 1% owners, or 5%+ owners, do not receive more than 25% of the total nontaxable benefits provided under the plan. In organizations with a heavily senior executive population, this concentration test can be surprisingly tricky to pass without intentional plan design.
The consequence of failure is significant but targeted: HCIs and key employees lose their tax-favored treatment and must include their cafeteria plan benefits in gross income. Non-HCIs are unaffected, and the plan itself remains valid, but the tax and payroll exposure for affected individuals and the employer can be substantial.
Premium Only Plans (POP): The foundation everyone overlooks
A Premium Only Plan (POP) is the most basic form of a Section 125 cafeteria plan , it allows employees to pay their share of employer-sponsored health insurance premiums on a pre-tax basis. If you have pre-tax payroll deductions for health insurance in your organization, you almost certainly have a POP, whether you formalized it or not.
Here's what brokers and HR teams miss: a POP must have a written plan document, and it must be tested for nondiscrimination. A POP without a proper plan document isn't just non-compliant; it means pre-tax deductions may not legally be pre-tax at all. The IRS does not recognize informal arrangements.
The nondiscrimination testing for a POP mirrors the Section 125 requirements: eligibility, contributions and benefits, and key employee concentration. But because POPs are so often treated as "set and forget" administrative items, testing is routinely skipped, creating quiet, compounding risk that often surfaces only during an audit or a benefits review.
Plan elections, benefit design choices, and documentation all interact under POP rules. Getting one wrong can undermine the others.
Section 105(h): The self-funded plan test most employers skip
For organizations that sponsor self-funded (self-insured) medical plans, Section 105(h) of the Internal Revenue Code layers on an additional set of nondiscrimination requirements. This is one of the most frequently overlooked obligations in the entire benefits compliance landscape.
Under 105(h), a self-insured health plan cannot discriminate in favor of HCIs with respect to either eligibility or benefits. The two tests are:
The eligibility test: The plan must pass at least one of three eligibility tests, the 70%/80% test (70% of all employees are eligible, and 80% of those actually benefit), the nondiscriminatory classification test (the plan benefits a reasonable classification of employees based on objective business criteria), or the safe harbor test.
The benefits test: The plan cannot provide better benefits to HCIs than to non-HCIs. This is tested at both the design level (plan terms cannot favor HCIs) and the operational level (how the plan actually runs in practice). Better eligibility terms, lower cost-sharing, or broader coverage for executives creates a failing condition.
The consequence of a 105(h) failure is immediate and non-correctable after the fact: discriminatory benefits become taxable income to HCIs. And critically, if those self-insured benefits are being delivered through a Section 125 cafeteria plan, a 105(h) failure can trigger a cascade, because highly compensated employees' cafeteria plan contributions may also lose their tax-favored status.
Most benefits advisors recommend testing mid-year, typically in June or July, as a projection, and then again at year-end with complete data. Running only at year-end eliminates any window for corrective action.
High-risk plan patterns: Red flags every broker should recognize
Discrimination testing failures rarely happen randomly. They follow predictable patterns that benefit brokers and HR professionals can be trained to spot. Here are the highest-risk scenarios:
Tiered benefit structures for executives. Any plan design that provides richer benefits, lower deductibles, or different coverage tiers for "officers" or "management" is immediately suspect under both 105(h) and Section 125 testing.
Executive-only HRA or reimbursement arrangements. Health Reimbursement Arrangements (HRAs) are powerful tools, but if they're offered exclusively or disproportionately to HCIs, they create 105(h) exposure. (Learn more about how employers are using HRAs strategically in our recent resource: How employers are using HRAs to manage rising health plan costs in 2026.)
Waiting period disparities. Different waiting periods for different employee classes, even when framed as business-justified, must withstand scrutiny under the nondiscriminatory classification standards.
Missing or outdated plan documents. ERISA problems routinely start here. Plans evolve faster than paperwork, and outdated documents that don't reflect actual plan operation are a compliance gap. (See our coverage of COBRA and regulatory complexity: How Clarity COBRA simplifies compliance in an increasingly complex regulatory environment.)
Integration gaps between platforms. When eligibility data, payroll deductions, and plan documentation live in disconnected systems, testing inputs become unreliable. Mid-year projection tests are only as good as the data behind them. The good news? Integrated platforms dramatically reduce this risk. (If you're already using Employee Navigator, you're closer to seamless Clarity integration than you might think: Already using Employee Navigator? You're closer to Clarity than you think.)
The testing calendar: When to run what
One of the most actionable takeaways from any compliance framework is timing. Here's the practical calendar:
- At plan inception or major plan design change: Run a projection test before the changes take effect. You cannot fix a discriminatory plan design retroactively.
- Mid-year (June–July): Run a projection using year-to-date data. This gives you time to adjust elections, plan contributions, or even plan design before year-end.
- Year-end: Run final tests using complete plan year data. Results must be documented and retained.
- Before the employer's tax return is filed: Tests must be complete. Documentation is required to support the pre-tax treatment claimed on W-2s and payroll returns.
Documentation isn't optional. If the IRS or DOL asks, you need to be able to produce the actual test, the data inputs, the results, and any corrective actions taken. "We ran the test informally" is not a defensible answer.
What comes next: join our June 23rd webinar
The complexity here is real, but it's manageable when you have the right framework. On June 23, 2026, at noon ET (11am CT), Clarity's own Edward Larned, Sr. VP of Sales, and Meredith Laroe, Director of Compliance, will walk benefit brokers, HR professionals, and consultants through a practical, step-by-step framework covering:
- How to run Section 125 and Section 105(h) tests correctly, and when
- How POP rules interact with broader cafeteria plan design
- How to spot high-risk plan patterns before they become failures
- How to document results and correct failures before audit exposure grows
- Specific strategies to protect the tax-favored status of benefits for all employees
This session is CE/SHRM certified, 60 minutes of practical compliance education you can apply immediately.
The bottom line
Discrimination testing is not a formality. In 2026, with heightened DOL scrutiny, evolving plan complexity, and real tax consequences for both employers and their most valued employees, getting this right has never mattered more. The plans that survive audits intact are the ones where someone, a broker, a consultant, an HR leader, took the time to understand the rules, run the tests, and document the results.
That's the kind of compliance confidence Clarity is built to deliver.
Schedule your consultation now.
Ready to take the next step? Get Clarity today, or request more information here to explore how we can simplify compliance for your organization.