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.
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.
Many plan administration errors arise from miscommunication, operational gaps, or limited familiarity with Section 125 regulations.
Under IRS rules, employees generally cannot change cafeteria plan elections mid-year. Changes are allowed only when:
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.
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.
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.
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.
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.
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:
Best Practices
When cafeteria plan errors occur, follow these core correction principles:
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.