HSA Non-Discrimination Testing: Section 125 and Comparability Rules

Employer contributions to employee Health Savings Accounts are subject to one of two completely separate non-discrimination regimes, and which one applies to HSA non-discrimination testing depends on a single structural question: do the contributions flow through a Section 125 cafeteria plan, or do they go directly into employee HSAs outside of one? Cafeteria plan contributions are tested under the three Section 125 non-discrimination tests. Direct contributions are governed by the comparability rules under Section 4980G. There is no overlap. You are in one lane or the other, and the penalties for getting it wrong look very different in each.

Which Framework Applies to Your HSA Contributions

Start with how the money reaches the account. If employees can choose between taxable compensation and pre-tax HSA contributions, or if the employer routes its own contributions through the cafeteria plan, you are in Section 125 territory and the comparability rules do not apply at all.1U.S. Department of the Treasury. Treasury and IRS Issue Final Regulations on Employer HSA Contributions

If the employer deposits money into employee HSAs directly, outside any cafeteria plan, Section 4980G governs. The comparability rules apply, and Section 125 testing does not.2Office of the Law Revision Counsel. 26 U.S. Code 4980G – Failure of Employer to Make Comparable Health Savings Account Contributions

Every other compliance obligation flows from that answer.

The Three Section 125 Tests

When HSA contributions run through a cafeteria plan, the employer has to pass three non-discrimination tests annually. The tests look at the entire cafeteria plan, not just the HSA piece. Passing all three preserves the pre-tax treatment of benefits for everyone in the plan.

Eligibility Test

The eligibility test asks whether a broad enough cross-section of non-highly compensated employees can enroll. A cafeteria plan cannot discriminate in favor of highly compensated individuals when it comes to who is eligible to participate.3Office of the Law Revision Counsel. 26 U.S. Code 125 – Cafeteria Plans A statutory safe harbor applies where the plan benefits a group of employees satisfying the classification test under Section 410(b), requires no more than three years of employment for eligibility, and does not require employees to reach an age above 21 to participate.

Contributions and Benefits Test

This test looks at whether the actual value of benefits elected by highly compensated employees significantly outpaces what other employees receive. The plan fails if qualified benefits or total benefits discriminate in favor of highly compensated participants.3Office of the Law Revision Counsel. 26 U.S. Code 125 – Cafeteria Plans Contribution formulas or benefit menus that channel more value to HCEs are the usual culprits.

Key Employee Concentration Test

The concentration test caps how much of the plan’s total non-taxable benefits can flow to Key Employees. If the qualified benefits provided to all Key Employees exceed 25% of the qualified benefits provided to all employees, the plan fails.3Office of the Law Revision Counsel. 26 U.S. Code 125 – Cafeteria Plans This is the test that catches small companies. When a handful of owners and officers make up a large share of the workforce, their elections push past 25% without any intentional favoritism in plan design.

Simple Cafeteria Plan Safe Harbor

Employers with 100 or fewer employees who received at least $5,000 in compensation the prior year can adopt a “simple cafeteria plan” under Section 125(j). A simple cafeteria plan is treated as satisfying all three non-discrimination tests automatically, provided the employer makes qualifying contributions for each eligible employee. For small employers, this eliminates annual testing.

Who Counts as an HCE or Key Employee

Before you can run the Section 125 tests, you have to classify every employee. Two separate classifications matter.

Highly Compensated Employees

For the 2026 plan year, an employee is an HCE if they meet either of two tests. The ownership test: anyone who owned more than 5% of the business at any point during 2025 or 2026 is an HCE regardless of pay.4Internal Revenue Service. Identifying Highly Compensated Employees in an Initial or Short Plan Year The compensation test: anyone who earned more than $160,000 in 2025 is an HCE for 2026.5Internal Revenue Service. Notice 2024-80 – 2025 Amounts Relating to Retirement Plans and Other Items The employer can optionally narrow this group to the top-paid 20% of employees who exceed the threshold.

Key Employees

Key Employees are a separate group used only for the concentration test. For 2026, the category includes:

The Comparability Rules for Direct Contributions

Section 4980G takes a completely different approach. Instead of testing outcomes across employee groups, the comparability rules impose a flat requirement: all comparable employees must receive the same employer HSA contribution.

The contribution must be the same dollar amount, or the same percentage of the annual HDHP deductible, for every employee in the same category.8Justia Law. 26 U.S. Code 4980E – Failure of Employer to Make Comparable Archer MSA Contributions The employer can only differentiate by two factors:

Contributions cannot vary by age, compensation, tenure, or anything else. Employees eligible for only part of the year receive a prorated amount based on months of eligibility.

Matching Contributions Do Not Work Here

This is the single most common trap. An employer cannot satisfy the comparability rules by matching each employee’s own HSA contributions. Employees make different elections, so identical match formulas produce different employer contributions and fail the comparability test.9U.S. Department of the Treasury. Final Regulations on Employer Comparable Contributions to Health Savings Accounts An employer that wants to offer matching contributions has to route them through a Section 125 cafeteria plan, where matches are exempt from comparability testing and evaluated under the Section 125 framework instead.10Federal Register. Employer Comparable Contributions to Health Savings Accounts Under Section 4980G

Collectively Bargained Employees

Employees covered by a collective bargaining agreement where health benefits were subject to good-faith bargaining are excluded from comparability testing. They are not comparable participating employees and are disregarded when determining whether contributions satisfy the rules.11Internal Revenue Service. Internal Revenue Bulletin 2006-33

Related Employers Get Combined

Businesses cannot avoid non-discrimination rules by splitting employees across separate entities. Under the controlled group and affiliated service group rules of Section 414, all employees of related businesses are treated as if they work for a single employer for testing.12Internal Revenue Service. Controlled and Affiliated Service Groups The comparability rules pick this up expressly: all persons treated as a single employer under Section 414(b), (c), (m), or (o) are treated as one employer for comparability testing.8Justia Law. 26 U.S. Code 4980E – Failure of Employer to Make Comparable Archer MSA Contributions

The common triggers are parent-subsidiary groups linked by 80% ownership, brother-sister groups with common ownership meeting statutory thresholds, and affiliated service groups in fields like healthcare, law, accounting, and consulting. If related entities exist, map them before running any test. Testing only one entity’s employees when a controlled group exists nearly guarantees failure once the IRS looks at the full picture.

What Happens When You Fail

The penalties differ sharply between the two frameworks, and they hit different people.

Section 125 Failure

When a cafeteria plan fails any of the three tests, the affected HCEs or Key Employees lose the pre-tax treatment of their benefits. They include the value of those benefits in taxable income for the plan year, even if they elected only qualified benefits. Non-HCEs and non-Key Employees are not affected.3Office of the Law Revision Counsel. 26 U.S. Code 125 – Cafeteria Plans HCEs who used pre-tax salary reduction to fund their HSAs owe income tax and payroll tax on those amounts retroactively, and the employer picks up additional payroll tax on the reclassified income. Corrective action during the plan year, usually by expanding NHCE participation or scaling back HCE elections before year-end, can head this off.

Comparability Failure

Failing the comparability rules triggers an excise tax of 35% of the total amount the employer contributed to all employee HSAs for that calendar year. Not 35% of the shortfall. Not 35% of the shortchanged employees’ contributions. 35% of every HSA dollar the employer put in that year.10Federal Register. Employer Comparable Contributions to Health Savings Accounts Under Section 4980G

You can avoid the excise tax by correcting the failure before April 15 of the year following the year of the non-comparable contributions. Correction means making additional contributions to the HSAs of shortchanged employees, bringing them up to comparable levels, plus reasonable interest. The IRS treats the federal short-term rate as reasonable.13Internal Revenue Service. Internal Revenue Bulletin 2006-33 The IRS may also waive part or all of the excise tax where the failure was due to reasonable cause and not willful neglect.8Justia Law. 26 U.S. Code 4980E – Failure of Employer to Make Comparable Archer MSA Contributions

Reporting the Excise Tax

Employers that owe the 35% excise tax report it on Form 8928. The filing deadline is the 15th day of the fourth month following the calendar year of the non-comparable contributions, which in most cases is April 15.14Internal Revenue Service. Instructions for Form 8928 Form 7004 gets you an automatic filing extension, but it does not extend the deadline to pay. The tax is due on the original filing date regardless.

Choosing Between the Two Structures

Direct contributions outside a cafeteria plan are simple: every comparable employee gets the same flat amount, and there is no annual Section 125 testing. The tradeoff is rigidity. No matching. No variation by compensation or tenure. And if anything goes wrong, a 35% excise tax on all HSA contributions for the year.

A cafeteria plan structure carries more administrative overhead and annual testing, but it opens up matching, salary reduction elections, and more flexible contribution design. If the plan fails, only the HCEs and Key Employees face tax consequences, not the employer’s whole contribution pool. For most employers with a mix of highly paid and rank-and-file workers, the cafeteria plan route offers more room to build a competitive benefit while keeping compliance risk manageable.