Section 125 Compliance Requirements for 2026

Running a Section 125 cafeteria plan is one of the smartest benefits decisions a company can make. But it comes with compliance obligations that, if ignored, can result in penalties, disqualified benefits, and unhappy employees.

The good news: compliance isn’t as complicated as it sounds. Most of the requirements are annual checklists rather than daily headaches. This guide walks through every major compliance area so you know exactly what’s required, what the deadlines are, and where companies most commonly slip up.

Plan Document Requirements

Every Section 125 plan must have a written plan document in place before the plan year begins. This isn’t optional — it’s the legal foundation of the entire plan. Without it, the IRS can disqualify pre-tax treatment for all participants. For a comprehensive guide to what your plan document must contain, see our Section 125 plan document requirements article.

What the Plan Document Must Include

The IRS requires that your Section 125 plan document contain:

• Description of each benefit available under the plan
• Eligibility requirements — who can participate and when
• Election procedures — how and when employees make their choices
• How employer contributions are made (if applicable)
• The plan year — start and end dates
• Maximum amounts for FSAs and other accounts
• Rules for mid-year election changes — qualifying life events
• Plan administrator identification

Common Plan Document Mistakes

1. Using a generic template without customization. Your plan document must reflect your actual plan design — the benefits you offer, your eligibility rules, your plan year.
2. Failing to update annually. IRS limits change every year (FSA limits, HSA limits, transit limits). Your plan document needs to reflect current numbers.
3. Not having the document signed before the plan year starts. You cannot retroactively establish a Section 125 plan. The document must be executed before the effective date.
4. Missing the Summary Plan Description (SPD). Participants are entitled to a written summary of the plan in plain language.

Nondiscrimination Testing

The IRS requires that Section 125 plans don’t disproportionately benefit highly compensated employees (HCEs) or key employees. Three primary tests apply, and they must be performed at least annually.

Who Is a Highly Compensated Employee?

For 2026, an HCE is generally an employee who:

• Owned more than 5% of the business at any time during the current or preceding year, OR
• Earned more than $155,000 in the preceding year (2025 threshold for 2026 plan years)

Who Is a Key Employee?

A key employee is:

• An officer earning more than $220,000 in 2026
• A 5% owner
• A 1% owner earning more than $150,000

The Three Tests

1. Eligibility Test

This test checks whether the plan’s eligibility requirements unfairly exclude non-HCEs. The plan must benefit a classification of employees that the IRS considers nondiscriminatory.

What triggers a failure: Eligibility rules that, in practice, let most HCEs participate while excluding a significant portion of non-HCEs — for example, a lengthy waiting period that mainly affects hourly workers.

2. Benefits and Contributions Test

This test ensures that HCEs don’t receive a disproportionate share of the plan’s benefits. The benefits available to HCEs must also be available to non-HCEs on a nondiscriminatory basis.

What triggers a failure: If HCEs elect significantly higher FSA contributions or more expensive benefit options than non-HCEs on average, the plan may fail this test.

3. Key Employee Concentration Test

This test checks whether key employees receive more than 25% of the total nontaxable benefits provided under the plan.

What triggers a failure: In smaller companies where owners or top officers have large pre-tax deductions relative to the rest of the workforce.

What Happens If You Fail?

If your plan fails nondiscrimination testing:

• HCEs lose their pre-tax treatment. Their benefits become taxable income.
• Non-HCEs keep their benefits. They’re not penalized.
• The employer may need to file corrected W-2s and pay additional payroll taxes.

The fix is usually to adjust plan design — broaden eligibility, cap HCE contributions, or increase employer contributions for non-HCEs.

Safe Harbor: Simple Cafeteria Plan

Employers with 100 or fewer employees can adopt a Simple Cafeteria Plan under IRC Section 125(j), which is deemed to satisfy nondiscrimination requirements. The trade-off: you must meet minimum eligibility and contribution requirements.

ERISA Compliance

Most Section 125 plans fall under ERISA (Employee Retirement Income Security Act), which adds several compliance requirements.

ERISA Requirements for Section 125 Plans

Requirement	Details
Summary Plan Description (SPD)	Must be provided to participants within 90 days of becoming eligible. Must be written in plain language.
Plan Document	Must be maintained and available for inspection by participants.
Form 5500	Required for welfare benefit plans with 100+ participants (applies to FSAs, not POP-only plans).
Claims Procedure	Must have a written procedure for filing and appealing benefit claims.
Fiduciary Duties	Plan administrators must act in the best interest of participants.

ERISA Exemptions

Some components of a Section 125 plan may be exempt from ERISA:

• Premium-only plans (POPs) that don’t involve employer contributions are generally exempt from Form 5500 filing.
• HSAs are individual accounts and generally not considered ERISA plans.
• Group insurance policies where the employer doesn’t contribute may have limited ERISA obligations.

COBRA Compliance

If your company has 20 or more employees, COBRA applies to the health benefits offered through your Section 125 plan.

COBRA and Section 125 Interactions

• Health FSAs are subject to COBRA, but there’s an exception: if the maximum COBRA premium for the FSA would exceed the maximum benefit available, COBRA doesn’t apply (this is true in most cases).
• Health insurance premiums paid through a Section 125 plan trigger COBRA rights when a qualifying event occurs.
• DCAPs and HSAs are not subject to COBRA.

Key COBRA Requirements

1. Initial COBRA notice must be provided to new plan participants.
2. Qualifying event notice must be sent within 14 days of the administrator learning of a qualifying event.
3. Election period is 60 days from the later of the qualifying event or the date notice is provided.
4. Coverage duration is generally 18 months (36 months for certain events).

Failure to comply with COBRA can result in excise taxes of $100/day per affected individual (up to $200/day for family coverage).

ACA Reporting Requirements

The Affordable Care Act adds reporting obligations for employers offering health coverage through a Section 125 plan.

Applicable Large Employers (ALEs)

If you had 50 or more full-time equivalent employees in the prior year, you’re an ALE and must:

• File Forms 1095-C and 1094-C annually with the IRS
• Provide Form 1095-C to each full-time employee by March 2 (for the prior calendar year)
• Report the cost of employer-sponsored health coverage on Form W-2 Box 12, Code DD

Affordability Standard

For 2026, employer-sponsored coverage is considered affordable if the employee’s required contribution for self-only coverage doesn’t exceed 9.02% of their household income. Since employers don’t know household income, safe harbors based on W-2 wages, rate of pay, or the federal poverty line are commonly used.

Section 125 and ACA Interplay

The pre-tax nature of Section 125 deductions doesn’t affect ACA affordability calculations when using the W-2 safe harbor — the W-2 amount already reflects the reduced wages. However, if using the rate-of-pay safe harbor, you use the gross rate of pay before Section 125 deductions.

Common Violations and Penalties

Here are the most frequent compliance failures we see:

1. No Written Plan Document

Penalty: All pre-tax deductions could be reclassified as taxable income. Corrected W-2s would need to be filed. Employer and employees owe back taxes.

2. Allowing Prohibited Mid-Year Changes

The issue: An employee wants to drop coverage mid-year because they “don’t need it anymore.” That’s not a qualifying life event.

Penalty: If the plan allows changes outside of qualifying life events, the entire plan could be at risk of disqualification.

3. Failing Nondiscrimination Testing (or Not Testing at All)

Penalty: HCEs lose pre-tax treatment. Corrected W-2s and additional taxes.

Many small businesses simply don’t know they need to perform these tests. If you have a Section 125 plan, testing is required — period.

4. Missing COBRA Notices

Penalty: Excise tax of $100–$200/day per affected individual, plus potential lawsuits.

5. Late or Incorrect ACA Reporting

Penalty for late filing: $60–$310 per return depending on how late, up to a maximum of $3,783,000 for large employers.

6. FSA Reimbursement Errors

The issue: Reimbursing ineligible expenses, allowing reimbursement after termination (without COBRA election), or exceeding annual limits.

Penalty: Plan could lose qualified status; reimbursements become taxable.

7. Not Updating the Plan for New IRS Limits

The issue: Using last year’s FSA or transit limits in the current plan year.

Penalty: If employees contribute above the legal limit, excess contributions are taxable and must be corrected.

2026 Annual Compliance Checklist

Use this timeline to stay on track throughout the year:

Before the Plan Year Begins (Q4 of Prior Year)

• Update plan document with current-year IRS limits
• Distribute open enrollment materials to employees
• Conduct open enrollment meetings or online enrollment
• Collect and process benefit elections
• Send COBRA initial notices to new participants

Q1 (January - March)

• Verify payroll deductions match employee elections
• Begin processing FSA claims for new plan year
• Distribute Form 1095-C to employees (by March 2)
• File Forms 1094-C and 1095-C with IRS (by March 31 for electronic filing)
• Process prior-year FSA grace period claims (if applicable)
• Run-out period for prior-year FSA claims (typically 90 days)

Q2 (April - June)

• Perform mid-year nondiscrimination testing (recommended)
• Review qualifying life event changes for proper documentation
• Verify COBRA notices are being sent timely
• File Form 5500 if required (due by July 31 for calendar-year plans)

Q3 (July - September)

• Review plan participation rates
• Assess whether plan design changes are needed for next year
• Begin planning for open enrollment
• Review and update employee communication materials

Q4 (October - December)

• Conduct year-end nondiscrimination testing
• Finalize plan amendments for coming year
• Hold open enrollment for the next plan year
• Distribute Summary of Material Modifications if plan changed
• Remind employees of FSA deadlines and balances
• Update plan document with new IRS limits for the coming year

Working With a TPA

Most companies — especially those with fewer than 200 employees — work with a Third-Party Administrator (TPA) to handle Section 125 compliance. A good TPA will:

• Draft and maintain your plan document
• Process FSA claims and reimbursements
• Perform annual nondiscrimination testing
• Handle COBRA administration
• Provide employee communication materials
• Keep you updated on regulatory changes

Typical cost: $500–$3,000/year depending on plan complexity and company size. Given that the employer FICA savings alone typically run $5,000–$50,000+ annually, the ROI is substantial.

When to Get Help

While this guide covers the major compliance areas, every company’s situation is different. Consider consulting a benefits attorney or compliance specialist if:

• You’re setting up a Section 125 plan for the first time
• Your plan has failed nondiscrimination testing
• You’ve received an IRS inquiry or audit notice
• You’re making significant changes to your plan design
• You have questions about how ACA requirements interact with your plan

The cost of professional guidance is a fraction of the cost of a compliance failure.

Need help evaluating your compliance posture? Contact us to discuss your Section 125 plan requirements.

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This guide is for informational purposes and does not constitute tax or legal advice. Consult with a qualified tax professional or benefits advisor for guidance specific to your situation.