Introduction

Employers often want flexibility when designing employee benefits. Whether it's offering enhanced benefits to management, varying contributions by employee class, or creating different eligibility rules for different groups of employees, these decisions can serve legitimate business goals.

However, benefit differentiation comes with important compliance considerations. While employers generally have some flexibility to structure benefits differently for various employee groups, federal nondiscrimination rules can limit how far those distinctions can go, particularly when benefits receive favorable tax treatment.

The challenge is that there is rarely a simple yes-or-no answer. A benefit design that works for one employer may create compliance issues for another, depending on workforce demographics, compensation levels, participation rates, and plan structure.

This article explores the key nondiscrimination rules that apply to employee benefits, how they affect common benefit design decisions, and what employers should consider before implementing differentiated benefit programs.

Key Takeaways

• Providing special benefit arrangements for individual employees can create discrimination risks and should generally be avoided.
• Differentiating benefits by legitimate employee classifications—such as salaried versus hourly employees or different locations—is often permissible but may require nondiscrimination testing.
• Most tax-favored employee benefits are subject to IRS nondiscrimination rules designed to prevent plans from disproportionately favoring highly compensated or key employees.
• Employers may need to perform multiple nondiscrimination tests depending on the types of benefits offered.
• Failing nondiscrimination testing can result in adverse tax consequences for highly compensated and key employees.
• Annual testing can help identify issues early and provide opportunities to make corrections before the end of the plan year.

Why Individualized Benefit Arrangements Create Risk

A common employer question is whether a specific employee can receive different benefits than everyone else.

Examples include:

• Shortening a waiting period for a new hire
• Providing enhanced employer contributions for a key employee
• Offering unique plan options to a high-performing employee
• Providing opt-out incentives to select individuals

While employers may have valid business reasons for these requests, providing benefits on an employee-by-employee basis creates significant compliance concerns.

Protected Class Considerations

Even when discrimination is not intended, individualized benefit decisions can create the appearance of unequal treatment. Employees may believe benefit differences are tied to protected characteristics such as:

• Age
• Gender
• Disability status
• Health status
• Race
• Religion
• National origin

Because of this risk, employers are generally better served by applying benefit distinctions consistently across defined employee groups rather than making exceptions for individuals.

Understanding the Rules That Limit Benefit Differentiation

Several federal laws influence how employers can structure benefit programs.

ERISA Requirements

Under ERISA, employers are generally expected to offer benefits consistently within bona fide classifications of employees.

Examples may include:

• Salaried versus hourly employees
• Different geographic locations
• Distinct job classifications

HIPAA Nondiscrimination Rules

HIPAA prohibits discrimination based on health status. Employers generally cannot structure eligibility, contributions, or costs in ways that favor healthier employees over those with medical conditions.

These rules also form the foundation for many wellness program requirements.

Age Discrimination Considerations

For employers offering age-rated fully insured plans, contribution strategies must be carefully designed to avoid discrimination concerns under the Age Discrimination in Employment Act (ADEA).

Medicare Secondary Payer Rules

Employers with 20 or more employees generally cannot encourage Medicare-eligible employees to leave the employer-sponsored plan in favor of Medicare.

Other Employment Law Protections

Additional protections may apply under:

• Title VII of the Civil Rights Act
• Americans with Disabilities Act (ADA)
• Genetic Information Nondiscrimination Act (GINA)

These laws can affect how benefits are designed and administered.

The IRS Tax Benefit Nondiscrimination Rules

When employers offer benefits on a tax-favored basis, the IRS imposes additional nondiscrimination requirements.

The core principle behind these rules is straightforward:

Tax-favored benefits should not disproportionately favor highly compensated or key employees.

Because most employers offer benefits through tax-advantaged arrangements, these rules are often the most significant compliance consideration when differentiating benefits.

Why the IRS Cares

The IRS allows:

• Employer contributions to be excluded from taxable income
• Employee contributions to be made on a pretax basis
• Certain account-based benefits to receive favorable tax treatment

In exchange, employers must satisfy nondiscrimination requirements.

If a plan fails testing, the entire plan is not typically disqualified. Instead, highly compensated and key employees may lose the tax advantages associated with participation.

Which Benefits Are Subject to Nondiscrimination Testing?

Different benefit programs are governed by different sections of the Internal Revenue Code.

Section 125 Cafeteria Plans

Applies to benefits offered through a cafeteria plan, including:

• Medical plans
• Dental plans
• Vision plans
• Health FSAs
• Dependent Care FSAs
• HSAs (when offered through the cafeteria plan)

Section 105(h)

Applies to self-funded health plans, including:

• Self-funded medical plans
• Self-funded dental plans
• Self-funded vision plans
• Health Reimbursement Arrangements (HRAs)
• Health FSAs

Section 129

Applies to Dependent Care Assistance Programs (DCAPs).

Section 79

Applies to employer-provided group term life insurance.

Additional Rules

Other nondiscrimination provisions apply to:

• Educational assistance programs
• Adoption assistance programs

Because many employers offer multiple benefit types, several testing requirements may apply simultaneously.

Who Is Considered a Highly Compensated Employee?

The definition depends on which nondiscrimination rule applies.

For Section 125 and Section 129 Testing

Generally includes:

• Certain officers
• Employee-owners with more than 5% ownership
• Employees earning above the IRS compensation threshold

For 2026 testing, that compensation threshold is generally $160,000 based on prior-year earnings.

For Section 105(h) Testing

The definition is different.

Highly compensated individuals generally include:

• Certain officers
• Employee-owners
• The top 25% highest-paid employees

This difference can produce very different testing outcomes even within the same organization.

Common Benefit Design Strategies and Compliance Considerations

Many employers seek to differentiate benefits for legitimate business reasons.

Common examples include:

Different Waiting Periods

Examples:

• Salaried employees eligible immediately
• Hourly employees eligible after 60 days

Different Plan Options

Examples:

• Managers offered multiple medical plan options
• Other employees offered fewer choices

Different Employer Contributions

Examples:

• Greater contributions based on years of service
• Enhanced contributions for certain employee groups

These arrangements are not automatically prohibited.

However, they often require nondiscrimination testing to determine whether they disproportionately favor highly compensated employees.

How Nondiscrimination Testing Works

Many employers are surprised to learn that nondiscrimination testing involves multiple separate tests.

Section 125 Testing

Cafeteria plans generally require:

1. Eligibility Test
2. Contributions and Benefits Test
3. Key Employee Concentration Test

Employers must pass all applicable tests.

Section 105(h) Testing

Generally includes:

• Eligibility Test
• Benefits Test

Section 129 Testing

Dependent care plans require four separate tests, including:

• Eligibility testing
• Contributions testing
• Ownership testing
• Average benefits testing

The average benefits test is often the most challenging for employers to satisfy.

What Information Is Needed for Testing?

Testing requires significant employee and plan data.

Employers typically need to provide:

• Complete employee census data
• Compensation information
• Officer designations
• Benefit eligibility information
• Participation data
• Contribution amounts
• Details regarding employer contributions

Organizations that are part of a controlled group or affiliated service group may also need to include employees from related entities in testing calculations.

How Often Should Employers Perform Testing?

There is no explicit requirement that employers perform testing annually.

However, annual testing is generally considered the most prudent approach.

Testing early in the plan year can:

• Identify issues before they become significant
• Allow time for corrections
• Reduce potential tax exposure
• Provide greater confidence when making benefit design changes

Some employers that consistently pass testing and make few plan changes may choose to test less frequently, but annual reviews provide the strongest compliance position.

What Happens If a Plan Fails Testing?

A failed test does not automatically trigger penalties.

However, if the IRS audits the plan and determines the nondiscrimination requirements were not satisfied, the tax-favored treatment for highly compensated or key employees may be reversed.

Potential consequences can include:

• Additional taxable income for affected employees
• Amended payroll reporting
• Additional payroll taxes
• Interest and penalties

Corrective Actions

If testing identifies a problem during the plan year, employers may be able to:

• Limit future pretax contributions
• Reclassify certain amounts as taxable income
• Reduce participation levels for highly compensated employees
• Adjust contribution limits

The available correction methods depend on the specific plan involved.

Proactive Strategies for Employers

Organizations that repeatedly struggle with nondiscrimination testing may consider proactive design changes.

Potential strategies include:

Limiting Highly Compensated Employee Participation

In some cases, employers may restrict participation in certain benefits, such as dependent care FSAs, for highly compensated employees.

Applying Lower Contribution Limits

Employers may allow participation but establish lower limits for highly compensated employees.

Expanding Participation Among Non-Highly Compensated Employees

Increasing eligibility or encouraging broader participation can improve testing outcomes and reduce the likelihood of future failures.

Final Thoughts

Employers have considerable flexibility when designing benefit programs, but that flexibility is not unlimited. Differentiating benefits by employee class, location, or job category may be permissible, yet the tax-favored nature of many benefit programs introduces a layer of nondiscrimination requirements that must be carefully considered.

Because outcomes depend heavily on workforce demographics, compensation levels, participation patterns, and plan design, there is rarely a universal answer. Employers considering differentiated benefits should evaluate the potential impact of nondiscrimination testing before implementing changes and periodically review their plans to ensure continued compliance.

Disclaimer: This content is provided for general informational purposes only and is not intended as insurance, tax, or legal advice. Coverage, terms, and availability can vary by carrier and state. Employers should consult with their legal, tax, or employee benefits advisors regarding their specific circumstances.

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