Question: How do employers address a failure to withhold the correct employee pre-tax salary reduction contributions through the cafeteria plan for prior pay periods?

Short Answer: Employers generally have three straightforward options to address missed Section 125 cafeteria plan contributions. However, if the missed contributions extend back to a prior plan year or the affected employee has terminated employment, the correction approach is somewhat more complex.

General Rule: Irrevocable Elections

The general rule under Section 125 is that employee health and welfare plan and FSA elections (including an affirmative or default election not to participate) to make employee contributions on a pre-tax basis through the cafeteria plan must be:

• Made prior to the start of the plan year; and

• Irrevocable for the plan year unless the employee experiences a permitted election change event.

For full details, see our 2022 Newfront Section 125 Cafeteria Plans Guide.

Note: Special relaxed election change rules were available in 2020 and 2021 related to the COVID-19 pandemic. For more details, see: The IRS CAA Cafeteria Plan Relief Guidance.

General Rule: Uniform Interval for Employee Salary Reductions

The Section 125 cafeteria plan regulations that govern employee pre-tax contributions for FSA and health and welfare plan premiums require that the interval for employee salary reductions be uniform for all participants. This means that you cannot have one employee making contributions at a different interval than another employee (e.g., one employee contributes each semi-monthly paycheck, while another employee contributes once per month).

Although it’s not explicit in the regulations that salary contributions be taken ratably, it would defeat the purpose of the uniform interval requirement to provide that employees may be paying different amounts at the set uniform interval. Therefore, most view doubling-up on contributions as not permitted under Section 125.

For example, assume an employee elects to contribute $5,000 to the dependent care FSA, and the company has 24 pay periods. The contribution per semi-monthly pay period is $208.33 ($5,000/24). It cannot be $300 one pay period, $200 the next, etc. The contributions must be taken ratably throughout the year.

For more details, see our previous posts:

• No FSA Contributions from Bonus Payments

• Final Paycheck Issues

• Issues with Employee HSA Front-Loading through Payroll

Correcting Mistakes: Missed Cafeteria Plan Contributions

Although the general rule is that employees’ elections are irrevocable and their contributions must be taken ratably on a uniform interval throughout the plan year, employers have greater flexibility in how to address an employer mistake that results in missed employee contributions.

Where an employer discovers that it has inadvertently failed to take the correct elected employee salary reduction contribution amount through payroll in prior pay periods, the employer generally has three options available to correct the mistake:

1. Spread Repayment Over Multiple Pay Periods: Employers can choose to collect the correct missed contributions over some or all of the remaining pay periods of the plan year. Employers should notify employees of this approach in advance so they will be aware of the additional withholding from their payroll to address the retroactive contributions.

Employees will have already authorized the full withholding by making the original election to contribute, and therefore employers do not need employees’ approval to proceed with the corrective measure to true-up the contributions over the remainder of the plan year.

Sample employee communication: During a recent system audit, we discovered that your year-to-date payroll contributions for [Medical/Dental/Vision/FSA/etc.] have been underfunded. We will be correcting this error going forward by taking your correct contribution amount plus an additional amount per pay period (for a total combined per-pay period amount of [Enter Amount]) that is designed to ensure you reach your desired salary reduction contribution amount through payroll by the end of the plan year. Please contact People Operations with any questions.

2. Lump Sum Repayment: Alternatively, employers can choose to correct missed contributions by withholding the amount owed in a single lump sum through one payroll prior to the end of the plan year. Employers should notify employees of this approach in advance so they will be aware of the additional withholding from their payroll to address the retroactive contributions.

Employees will have already authorized the full withholding by making the original election to contribute, and therefore employers do not need employees’ approval to proceed with the corrective measure to true-up the contributions in a single lump sum. However, employers should consider the potential hardships the lump sum approach may cause employees, particularly in light of the amount at issue and the affected employees’ compensation levels.

Sample employee communication: During a recent system audit, we discovered that your year-to-date payroll contributions for [Medical/Dental/Vision/FSA/etc.] have been underfunded. We will be correcting this error by taking a one-time corrective contribution amount of [Enter Amount] in an upcoming pay period that is designed to ensure you reach your desired salary reduction contribution amount through payroll by the end of the plan year. This one-time corrective contribution amount will be in addition to your standard per-pay period contribution, which has been corrected. Please contact People Operations with any questions.

3. Convert Missed Amounts to Employer Contributions: One final approach is for employers to simply forgive the missed employee contributions without requiring the employee to repay the missed amount. There should not be any issue with taking this approach in a corrective context to address a bona fide employer error. This approach is the costliest for the employer, but also the simplest and least likely to cause employee relations issues related to the mistake.

Under this approach, the affected employees will still need to have the full elected coverage (e.g., premium only plan contributions for medical/dental/vision) or balance available for reimbursement (e.g., health FSA or dependent care FSA) despite missing some amount of the contributions associated with that election. In other words, this approach is effectively the equivalent of converting the missed employee contributions to employer contributions as a corrective measure—the employer is covering the cost for the amount they failed to withhold from the employee’s paycheck.

Sample employee communication: During a recent system audit, we discovered that your year-to-date payroll contributions for [Medical/Dental/Vision/FSA/etc.] have been underfunded. We will be correcting this error by forgiving your missed contributions and withholding your corrected elected contribution amount through payroll for each pay period remaining in the plan year. You will still have access to the full benefits you elected for the plan year. Please contact People Operations with any questions.

Prior-Year Mistakes: Missed Cafeteria Plan Contributions from the Prior Plan Year

Where an employer discovers that it is has inadvertently failed to take the correct elected employee salary reduction contribution amount through payroll in the prior plan year, the employer has three potential options available to correct the mistake:

1) Employee Pre-Tax Contributions in Year Two for Year One Missed Contributions

There is no formal IRS guidance confirming that an employer can take employee pre-tax contributions in year two to address missed contributions for year one. However, we think this is a low-risk approach that is very unlikely to present any issues.

In practice, this is essentially the same approach that employers will commonly apply to address employee pre-tax contributions for a period of leave where the employee is utilizing the catch-up payment option. In that case, employers generally feel comfortable taking an employee pre-tax contribution upon return from leave to cover the full period of the leave—even where that leave straddles two plan years.

Again, although the IRS has not formally approved of that approach, it is a common practice that is generally considered low risk. Note that the pre-pay contribution option is not available to address a period of leave extending to a subsequent plan year because that would violate the Section 125 prohibition of deferral of income rules.

For full details, see:

• 2022 Newfront Health Benefits While on Leave Guide

• Health Benefits During Protected Leave

Furthermore, the employee pre-tax payment in year two approach may also be a good fit to address a situation where the employer discovers a missed contribution error late in year one and wants to spread the repayment over more pay periods than remain available in year one.

Employers utilizing this pre-tax employee contribution option in year two to address missed contributions in year one will want to keep the following issues in mind:

• Although it is unlikely to present any issues with the IRS, there is no formal guidance approving this approach;

• If the correction relates to missed FSA contributions from year one, it may require a manual override in year two to exceed the annual limit because payroll systems generally are setup to prevent pre-tax FSA contributions in excess of the applicable annual limit; and

• Employees may terminate employment in year two prior to the full amount of missed contributions being repaid, which would require the employer to either a) absorb the cost, or b) attempt to seek repayment by check.

Employers should notify employees of this approach in advance so they will be aware of the additional withholding from their payroll in year two to address the retroactive contributions from year one. Employees will have already authorized the full withholding by making the original election to contribute, and therefore employers do not need employees’ approval to proceed with the corrective measure to take the corrective pre-tax contributions in year two.

Sample employee communication: During a recent system audit, we discovered that your [Enter Year] payroll contributions for [Medical/Dental/Vision/FSA/etc.] were underfunded. We will be correcting this error by taking your missed contribution amounts through [an upcoming pay period or upcoming pay periods]. These corrective contributions will be [a one-time or per pay period] amount of [Enter Amount] taken on a pre-tax basis. Please contact People Operations with any questions.

2) Employee After-Tax Contributions in Year Two for Year One Missed Contributions

The more conservative approach would be to require that the employee make the missed year one contributions on an after-tax basis. Employees could make these after-tax contributions in year two through payroll or by direct payment (e.g., check). This approach is of course less advantageous from a tax perspective to both parties.

Where utilizing after-tax payroll contributions, employers should notify employees of this approach in advance so they will be aware of the additional withholding from their payroll in year two to address the retroactive contributions from year one. Employees will have already authorized the full withholding by making the original election to contribute, and therefore employers do not need employees’ approval to proceed with the corrective measure to take the corrective after-tax contributions in year two.

Sample employee communication: During a recent system audit, we discovered that your [Enter Year] payroll contributions for [Medical/Dental/Vision/FSA/etc.] were underfunded. We will be correcting this error by taking your missed contribution amounts through [an upcoming pay period or upcoming pay periods]. These corrective contributions will be [a one-time or per pay period] amount of [Enter Amount] taken on an after-tax basis. Please contact People Operations with any questions.

3) Convert Missed Amounts to Employer Contributions

One final approach is for employers to simply forgive the missed employee contributions without requiring the employee to repay the missed amount. There should not be any issue with taking this approach in a corrective context to address a bona fide employer error. This approach is the costliest for the employer, but also the simplest and least likely to cause employee relations issues related to the mistake.

Under this approach, the affected employees still need to have had the full elected coverage (e.g., premium only plan contributions for medical/dental/vision) or balance available for reimbursement (e.g., health FSA or dependent care FSA) in the prior plan year despite missing some amount of the contributions associated with that election. In other words, this approach is effectively the equivalent of converting the missed employee contributions to employer contributions as a corrective measure—the employer is covering the cost for the amount they failed to withhold from the employee’s paycheck.

Sample employee communication: During a recent system audit, we discovered that your [Enter Year] payroll contributions for [Medical/Dental/Vision/FSA/etc.] were underfunded. We will be correcting this error by forgiving your missed contributions. Despite the error on our end, you still had access to the full benefits you elected for the [Enter Year] plan year. Please contact People Operations with any questions.

Terminated Employees: How to Correct Where Salary Reduction Contributions No Longer Possible

Where employees with missed contributions have already terminated from employment, payroll contributions are no longer an option. Employers could in theory request employees directly repay the missed amounts to the employer (e.g., by check). However, the practical reality is that it is unlikely the employer will ever recover these missed amounts, and therefore the best practice is generally to simply forgive the missed contributions as a corrective employer contribution.

Overcontributions: Returned as Taxable Income

Any amounts that an employer discovers were over-withheld from employees (i.e., salary reduction contributions in excess of the employee’s election) should be returned to employees as standard taxable income subject to withholding and payroll taxes. This may require corrections to the employee’s Form W-2 if discovered after the end of the year.

Mistaken Elections: The Informal IRS Doctrine of Mistake

IRS officials have provided informal guidance stating that an employee’s election can be corrected where there is “clear and convincing evidence” that a mistake has been made. The argument is that the employer is not changing the election mid-year in violation of the irrevocable election rules, but rather the employer is undoing the incorrect election and replacing it with the correct one.

The clear and convincing evidence required to utilize this IRS doctrine of mistake is a very high standard. There generally are only two situations where it is a viable option:

1. Employees elect to contribution in the dependent care FSA despite not having any eligible dependents to benefit from the election; or

2. A confirmed benefits administration system error that demonstrates the employee’s intended election was not properly implemented.

For more details, see:

• 2022 Newfront Section 125 Cafeteria Plans Guide

• Mistaken Enrollment in the Dependent Care FSA

• Benefits Administration System Error Caused Mistaken Election