Top Compliance Mistakes Employers Make with Section 125 Plans (And How to Avoid Them)

Compliance Can Be a Dealbreaker

Offering pre-tax benefits through a Section 125 Plan (also known as a Cafeteria Plan) is a smart financial move for both employers and employees. It helps reduce payroll taxes while giving employees more take-home pay—a true win-win.

But there’s a catch: compliance matters.

Failing to follow IRS regulations can lead to serious penalties, disqualified benefits, and unexpected tax liabilities. The good news? Most compliance issues are easy to avoid when you know what to look for.

This article will walk you through the most common compliance mistakes employers make with Section 125 Plans—and how The Policy Shop ensures you stay IRS-compliant and penalty-free.

(Compliance Mistakes Employers Make with Section 125 Plans)

Mistake #1: Not Having a Written Plan Document

📌 What’s Wrong?
The IRS requires all Section 125 Plans to have a formal written plan document that outlines:
✅ Eligibility rules (who can participate)
✅ Types of benefits offered
✅ How contributions are handled
✅ Election change rules

Without this document, your Section 125 Plan is not compliant—even if everything else is done correctly.

✅ How to Fix It:
The Policy Shop provides customized plan documents that meet IRS requirements, keeping your business protected.

Mistake #2: Allowing Mid-Year Election Changes Without a Qualifying Event

📌 What’s Wrong?
Once employees choose their pre-tax benefits during open enrollment, their elections must remain locked in for the entire plan year—unless they experience an IRS-approved qualifying life event such as:
✔️ Marriage or divorce
✔️ Birth or adoption of a child
✔️ Change in employment status
✔️ Loss of other coverage

Allowing employees to change their elections mid-year without a qualifying event violates IRS rules and can cause serious tax penalties.

✅ How to Fix It:
✔️ Educate HR and employees on mid-year election rules.
✔️ Only allow changes for approved qualifying events.
✔️ Work with The Policy Shop to ensure proper plan administration.

Mistake #3: Including Non-Qualified Benefits in the Plan

📌 What’s Wrong?
Not all benefits can be offered pre-tax under a Section 125 Plan. Employers sometimes accidentally include non-qualified benefits such as:
❌ Tuition reimbursement
❌ Non-prescription wellness products
❌ Employer-provided cell phones

Offering non-qualified benefits can invalidate the entire Section 125 Plan and result in tax penalties.

✅ How to Fix It:
✔️ Only include IRS-approved benefits, such as:

• Health insurance premiums
• Dental & vision coverage
• Flexible Spending Accounts (FSAs)
• Dependent Care Assistance Programs (DCAPs)
  ✔️ Consult with The Policy Shop to review your plan structure and avoid costly mistakes.

Mistake #4: Failing to Perform Non-Discrimination Testing

📌 What’s Wrong?
The IRS requires annual non-discrimination testing to ensure that Section 125 Plans don’t favor highly compensated employees (HCEs) or key employees over lower-paid workers.

Skipping this test (or failing it) means the plan loses its tax-exempt status, and HCEs may owe back taxes.

✅ How to Fix It:
✔️ Conduct non-discrimination testing annually (The Policy Shop provides assistance).
✔️ Ensure equal access to benefits for all employees.
✔️ If your plan fails the test, adjust contributions to restore compliance.

Mistake #5: Not Properly Documenting Employee Elections

📌 What’s Wrong?
Every employee who participates in a Section 125 Plan must formally elect their benefits during open enrollment. Missing documentation can lead to:
❌ Disputes over coverage elections
❌ Compliance violations
❌ IRS penalties if audited

✅ How to Fix It:
✔️ Require signed election forms (or digital consent for online enrollments).
✔️ Maintain accurate records of all elections & changes.
✔️ Work with The Policy Shop for secure, compliant record-keeping.

Mistake #6: Missing IRS Filing Deadlines

📌 What’s Wrong?
Many employers don’t realize that Section 125 Plans have reporting requirements, including:
✔️ Form 5500 (for plans with 100+ participants)
✔️ W-2 Reporting for pre-tax benefits

Missing these filings can result in costly IRS penalties.

✅ How to Fix It:
✔️ Partner with The Policy Shop to handle compliance reporting.
✔️ Stay on top of filing deadlines to avoid penalties.

How The Policy Shop Keeps Your Section 125 Plan Fully Compliant

Navigating IRS regulations can be overwhelming, but you don’t have to do it alone. The Policy Shop ensures your Section 125 Plan is:

✅ Properly documented with a legally compliant written plan
✅ Administered correctly with no mid-year election mistakes
✅ Free of non-qualified benefits that could trigger tax penalties
✅ Non-discriminatory, passing all IRS-required testing
✅ Accurately recorded, keeping your business audit-ready

📞 Need Help? Contact The Policy Shop today to ensure your Section 125 Plan is 100% IRS-compliant and worry-free!