FSA Nondiscrimination Testing for Health & Dependent Care FSAs

1. ? FSA Nondiscrimination Testing for Health & Dependent Care FSAs Flexible Spending Accounts (FSAs) offer employees valuable pre-tax savings on healthcare and dependent care expenses. However, these benefits come with regulatory obligations—chief among them is FSA nondiscrimination testing, a critical compliance measure required under the Internal Revenue Code (IRC). If your plan fails these tests, high-earning employees may lose the tax-free status of their contributions. This guide explores the purpose, requirements, and process for nondiscrimination testing for Health FSAs and Dependent Care FSAs (DCAPs), helping employers and benefits administrators understand how to maintain compliance and avoid costly penalties. What Is FSA Nondiscrimination Testing? ✅ FSA nondiscrimination testing is a set of annual evaluations designed to ensure that employers’ pre-tax benefit plans do not unfairly favor highly compensated or key employees. These rules apply to both: • Health FSAs – used for eligible out-of-pocket healthcare expenses.

2. • Dependent Care FSAs (DCAPs) – used for daycare or eldercare expenses to enable the employee (and spouse) to work. The IRS mandates that these plans must meet certain standards under: • Section 125 – for cafeteria plans including Health FSAs. • Section 129 – for Dependent Care Assistance Programs. Who Are "Highly Compensated" and "Key Employees"? ‍ Understanding the categories of employees that are subject to discrimination rules is critical. Highly Compensated Employees (HCEs): Defined under Section 414(q), these may include: • Employees who earned more than $150,000 (2023 limit, indexed annually). • Employees who own more than 5% of the company, regardless of salary. • Officers or family members of owners, in some cases. Key Employees (under Section 416(i)): Includes: • An officer with annual pay over $215,000 (2023). • A 5% owner of the business. • A 1% owner with annual pay over $150,000. Nondiscrimination tests ensure that HCEs and key employees do not disproportionately benefit from tax-favored plans. What Are the Required Nondiscrimination Tests? ? There are different tests based on the type of FSA offered. Employers must pass all applicable tests. For Health FSAs (Under Section 125): 1. Eligibility Test – Ensures sufficient non-HCEs are eligible to participate. 2. Benefits Test – Ensures the level of benefits isn’t skewed in favor of HCEs. 3. Key Employee Concentration Test – No more than 25% of total benefits can be received by key employees.

3. For Dependent Care FSAs (Under Section 129): 1. Eligibility Test – Confirms the plan doesn’t discriminate in favor of HCEs in terms of who can participate. 2. Contributions and Benefits Test – Evaluates whether contributions or benefits favor HCEs. 3. 55% Average Benefits Test – More than 55% of total benefits must go to non-HCEs. What Happens If a Plan Fails? ⚠️ If your FSA plan fails nondiscrimination testing, it does not invalidate the plan entirely—but it does make affected contributions taxable for the HCEs or key employees. For example, if a Health FSA fails the key employee concentration test, the affected key employees may owe income and payroll taxes on their FSA contributions. That undermines the primary benefit of an FSA—tax savings. This not only impacts employee satisfaction but could also create issues during an IRS audit or expose the company to penalties. When Should Testing Be Conducted? ? FSA nondiscrimination testing should be performed at least once per year, ideally: • Before the start of the plan year – using enrollment projections to identify potential risks. • Mid-year – especially if significant changes occur (like mergers or layoffs). • Year-end – using actual participation and contribution data for final compliance. Employers should not delay testing until after the plan year ends, as there is little time to correct imbalances retroactively. How to Conduct FSA Nondiscrimination Testing ️ While employers can technically perform testing in-house using IRS worksheets, most organizations partner with a compliance services provider like CXC Solutions to ensure accuracy. Steps typically include: 1. Collect employee census data – including compensation, ownership status, and participation. 2. Classify employees – into HCEs, key employees, non-HCEs, etc. 3. Apply IRS test criteria – using standardized formulas. 4. Analyze results – and flag any failures.

4. 5. Take corrective action if needed – such as adjusting benefits or contributions for affected groups. Best Practices for Employers ? To reduce the risk of discrimination testing failures, follow these tips: • Educate employees about FSA benefits to increase non-HCE participation. • Cap employer contributions for HCEs if tests are consistently failing. • Run early and frequent tests so you have time to adjust before year-end. • Use third-party compliance support to streamline the process and maintain audit readiness. Why Work with CXC Solutions? ? CXC Solutions offers full-service nondiscrimination testing as part of its compliance platform. Here’s why employers trust CXC: ? Expert Guidance – Deep understanding of IRS Section 125 and 129 regulations. • ? Custom Reports – Easy-to-understand results and guidance on next steps. • ⏱️ Fast Turnaround – Get compliance answers quickly so you can act. • ? Data Security – Your employee information is handled with care. • Whether you manage a small business or a large enterprise, CXC Solutions simplifies nondiscrimination testing—helping you stay compliant, avoid IRS issues, and maintain the integrity of your benefits plan. Learn more and request your testing service today ➝ Conclusion ? FSA nondiscrimination testing is not just a compliance checkbox—it’s a safeguard to ensure equitable tax benefits across your organization. With IRS rules constantly evolving, employers must be proactive in testing and correcting imbalances to protect the value of their Health and Dependent Care FSAs. By understanding the rules and working with trusted compliance experts like CXC Solutions, you can ensure that your benefits plan is fair, compliant, and valuable to all your employees.