Offering flexible benefit options is one way employers can attract and retain employees. But without careful design and compliance, the risks can outweigh the rewards. Section 125, the “cafeteria plan” rules outlined by the IRS, gives employers the ability to offer pre-tax benefit elections, but it comes with intricate regulatory obligations. This is especially true when it comes to benefit rewards, also known as forfeiture pools and nondiscrimination rules.
In this post, we walk through the fundamentals, spotlight key traps, and show how Prodigy Benefit Management helps employers implement and manage our Section 125 plan with confidence.
What Is a Section 125 Cafeteria Plan?
A cafeteria plan (IRC § 125) is a written employer benefit program under which employees can choose between taxable compensation (the employee’s paycheck) and one or more qualified benefits on a pre-tax basis. These elections allow employees to reduce their taxable income for certain benefits, and employers to reduce payroll tax exposure as well.
Typical qualified benefits under Section 125 include:
- Health, dental, vision coverage
- Health Flexible Spending Accounts (FSAs)
- Dependent care assistance (DCAP)
- Group-term life insurance (within IRS limits)
- Adoption assistance
- Other qualified benefits permitted by the plan design
To be valid, a cafeteria plan must be in writing and permit an election among at least two benefit options.
Because the election is made before the employee “receives” their paycheck, Section 125 helps avoid constructive receipt issues that otherwise could make the benefit taxable.
Key Rules Employers Must Master
Below are the essential compliance areas employers must navigate to maintain the tax-advantaged status of their Section 125 plans:
Written Plan Document & Plan Year
- The plan must be documented in writing, specifying the benefits available, eligibility, election mechanics, and forfeiture rules.
- A defined plan year (e.g., calendar year or fiscal year) must govern elections and contributions.
Irrevocability of Elections & Permitted Changes
- Generally, elections are irrevocable for the plan year.
- Changes may be allowed only upon qualifying status change events (marriage, birth, change in employment status) and must adhere to IRS rules (Treas. Reg. § 1.125-4).
- The plan must clearly define which change events are permitted and how they operate.
Use-It-or-Lose-It, Grace Periods, and Carryovers
- Unused FSA balances generally are forfeited at year’s end.
- However, a plan may allow a grace period after the plan year for qualifying expenses to be reimbursed under unused amounts (per IRS Notice 2005-42).
- Alternatively, the plan may allow a carryover of up to a specified dollar limit
Nondiscrimination Testing
To preserve the status of a Section 125 plan, employers must ensure the plan does not discriminate in favor of Highly Compensated Individuals (HCIs) or Key Employees. The IRS requires three main nondiscrimination tests:
Eligibility Test
- Ensures a sufficient number of non-HCIs are eligible to participate. The plan cannot exclude too many lower-paid employees.
- Requires that any service or age eligibility conditions apply uniformly and not delay entry unreasonably.
- If the plan varies benefit offerings or classes, it must meet a nondiscriminatory classification standard.
Contributions & Benefits Test
- Confirms that employer contributions or benefits available under the plan are offered on a nondiscriminatory basis.
- Assesses both the availability of benefits, ensuring they are offered equally to eligible participants, and utilization to ensure HCIs are not disproportionately electing benefits.
- A safe harbor may apply in limited cases
Key Employee Concentration Test
- Ensures that benefits allocated to key employees do not exceed a statutory threshold, traditionally limited to 25% of the non-taxable benefits.
- Prevents a plan from being overly biased toward top executives
Why this matters
- If the plan fails any of these tests, the tax advantages may be lost, typically for the HCIs or key employees rather than for all participants.
- Because the tests rely on detailed census, payroll, and benefit election data, accuracy and timely testing are critical.
- Many employers perform annual nondiscrimination testing, often before the end of the plan year, to catch issues early and make corrective adjustments if needed.
What Exactly Are “Benefit Rewards” and Why They Matter
Within a cafeteria plan, benefit rewards, also known as forfeiture pools, arise when employees make elective contributions but underspend them. These unused balances, once forfeited, revert to the employer or are otherwise applied under rules explicitly defined by the plan.
Tax Treatment
- Forfeitures are not treated as employee income since the funds were never “received”.
- Nonetheless, the disposition of forfeitures must comply with IRS rules and the plan’s written terms.
Permitted Uses
Typically, the plan may direct forfeitures toward:
- Offsetting plan administrative expenses
- Funding additional participant reimbursements
- Reducing future participant contributions
- Preventing benefit reductions or plan terminations
The plan document must explicitly permit those uses. Misuse, such as diverting funds for unrelated general corporate use, can jeopardize compliance, resulting in fines and more legal ramifications.
ERISA / Fiduciary Considerations
If the FSA or cafeteria plan is subject to ERISA, forfeiture funds are considered plan assets and must be used for the exclusive benefit of plan participants and not retained as corporate earnings. Any use of forfeitures must be consistent, fair, and nondiscriminatory.
Accounting & Disclosure
Employers must track forfeitures and allocations carefully, ensure they match the plan’s operational and document provisions, and provide transparency to participants in disclosures or plan update notices.
Because benefit rewards lie at the intersection of tax, fiduciary, and plan design risk, they demand deliberate treatment and professional oversight.
Common Pitfalls Employers Face
- Ambiguous or missing forfeiture provisions in plan documents
- Failing nondiscrimination tests, especially the contributions & benefits test or concentration test
- Permitting mid-year election changes outside permitted events, undermining irrevocability rules
- Overextending carryover or grace periods beyond IRS limits
- Inaccurate or inconsistent recordkeeping, reconciliation errors between payroll, reimbursements, and forfeitures
- Ignoring audit readiness or benchmarking, leaving exposure to IRS or DOL scrutiny
Even minor design or administrative misalignments can put the tax-advantaged status of a cafeteria plan in jeopardy, making proactive review essential.
How Prodigy Benefit Management Supports You
Designing and maintaining a compliant Section 125 cafeteria plan requires expertise, diligence, and regular oversight. Here’s how Prodigy Benefit Management helps employers.
Custom Plan Design & Document Drafting
Our tailored plan documents clearly define benefits, election procedures, forfeiture rules, and permitted use of rewards, all compliant with IRS guidance.
Nondiscrimination Testing & Compliance Review
Our team conducts Eligibility, Contributions & Benefits, and Key Employee Concentration tests, interprets results, and recommends corrective strategies.
Forfeiture Reserve Management
We assist in structuring, monitoring, and allocating benefit rewards in line with plan design, tax rules, and best practices.
Administration & Recordkeeping Support
From payroll integration and participant communications to reconciliation of elections, reimbursements, and forfeitures, we ensure plan operations align with the written document.
Ongoing Oversight, Review & Audit Preparation
We perform periodic compliance reviews, benchmarking, and help you prepare for IRS or DOL audits to mitigate risk. The Paradigm Integrated Healthcare Plan is IRS-compliant, and we offer up to $500,000 in audit defense in the event of an audit.
By letting Prodigy manage the complexity, you can deliver a robust, tax-advantaged employee benefit without undue administrative burden or compliance anxiety.
Final Thoughts on Section 125 Cafeteria Plans
Section 125 cafeteria plans remain a powerful lever for offering flexible, tax-efficient benefits, but they demand precision in design and implementation. Benefit rewards and nondiscrimination rules are among the most subtle yet consequential aspects where missteps can trigger serious tax or fiduciary consequences.
