A Section 125 or cafeteria plan lets employees pay for certain benefits with pre-tax dollars but only if the plan strictly follows IRS Section 125 rules and its written terms. If it doesn’t, elections between taxable and nontaxable benefits may be treated as taxable income, and errors can trigger additional issues under laws like ERISA and COBRA. While the IRS doesn’t spell out how to fix these mistakes, here are some practical best practices to help sponsors correct issues effectively and stay compliant.
Tips on Correcting Cafeteria Plan Administration Errors
To reduce cafeteria plan administration errors, it’s critical to understand how they happen and put safeguards in place. Many plan sponsors now run voluntary compliance reviews to spot and fix issues early. Below, we outline the most common mistakes, proven best practices, and key steps for correcting and preventing errors.
Common Mistakes
Many plan administration errors arise from miscommunication, operational gaps, or limited familiarity with Section 125 regulations.
Improper mid-year election changes without a qualifying event
Under IRS rules, employees generally cannot change cafeteria plan elections mid-year. Changes are allowed only when:
- The employee has an IRS‑recognized mid‑year event;
- The plan document specifically permits changes for that event; and
- The requested change matches the event (for example, adding a new dependent after birth).
If any of these conditions are not met, the election change is invalid, even if the life event seems to qualify. In addition, some IRS mid‑year events apply to all cafeteria plan benefits, while others apply only to certain benefits (such as health FSAs). That’s why it’s critical to review your plan document carefully and clearly define which mid‑year changes are allowed for each benefit.
Incorrect salary reduction holdings
Cafeteria plans let employees set aside a portion of their pay on a pre-tax basis to cover qualified benefits, such as health insurance. Elections are typically made prospectively during open enrollment or an initial enrollment for new hires and take effect on the first day of the new plan year. If salary reductions are miscalculated or applied retroactively so that the amount withheld does not match the employee’s authorized election, the plan can fall out of compliance with Section 125.
Offering or reimbursing non-qualified benefits under the plan
Cafeteria plans can include qualified benefits like accident and health coverage, adoption assistance, dependent care, and dental or vision benefits. They cannot include non-qualified benefits such as Archer medical savings accounts, long-term care insurance, or employer-provided meals and lodging. If non-qualified benefits are offered, the plan can lose its cafeteria status and employees’ elections may become taxable.
Enrollment Mistake
Eligibility errors in cafeteria plan administration often happen during open enrollment when ineligible employees are allowed to participate or eligible employees are left out. These mistakes can create salary reduction discrepancies and benefit payment errors, so it’s critical for employers to carefully review and adjust all affected benefits across the plan.
Failing to comply with applicable nondiscrimination rules
To keep your cafeteria plan tax-favored, it must pass annual nondiscrimination testing to ensure it doesn’t overly benefit highly compensated employees. If the plan fails, only highly compensated employees lose the tax advantage and must report these benefits as income; non-highly compensated employees keep their tax benefits. Because testing is complex and additional tests may apply to options like health and dependent care FSAs, most employers partner with a specialist and test early each plan year to allow time to make adjustments.
Key Details to Assess
When a plan administration error is identified, take time to assess it thoroughly so your correction is accurate and compliant. Key questions to consider include:
- How and why did the mistake occur (e.g., documentation gaps, training issues, or process failures).
- When did it occur (before, during, or across multiple plan years), and what are the tax and retroactive implications.
- How many participants or beneficiaries are affected. Is it an isolated issue or a systemic problem requiring broader action and advisor input.
- How long will corrective measures take, and what teams or systems must be involved to minimize disruption.
- Were other entities, such as a third-party administrator, involved, and how will you coordinate responsibilities and strengthen oversight going forward.
Best Practices
When cafeteria plan errors occur, follow these core correction principles:
- Gather complete documentation (elections, payroll, open enrollment communications, plan documents) as soon as an error is found.
- Use reasonable, good‑faith efforts to fix the problem and protect plan integrity, partnering with experienced benefits counsel when needed.
- Restore the plan and affected employees to the position they would have been in had the error not occurred (for example, by adjusting salary reductions or correcting elections).
- Apply the same correction method to all similarly situated employees to ensure fairness and compliance.
- Tailor corrections so they are reasonable and proportionate to the impact of the mistake.
- Put preventive safeguards in place, stronger enrollment procedures, periodic self‑audits, and regular plan document reviews, designed with benefits counsel to align with regulatory requirements and reduce future errors.
Employer Takeaway
Cafeteria plan administration errors are complex and carry real compliance risk. Because formal regulatory guidance is limited, employers should immediately work with benefits counsel or plan advisors to choose the right correction strategy. A thorough review of the cause, scope, and impact of the error not only supports proper correction, but it also strengthens the plan’s integrity and helps prevent future issues. Download the bulletin for more details.
Links and Resources
- Internal Revenue Code Section 125
- IRS’ proposed Section 125 regulations from 2007 (taxpayers may rely on these until final regulations are issued)
- IRS Publication 15-B, “Employer’s Tax Guide to Fringe Benefits” (provides an overview of cafeteria plan requirements)
- IRS Memorandum No. 201413006 (regarding correction procedures for improper health flexible spending arrangement payments
