Is a 401(k) a Section 125 Plan?

Employer-sponsored benefits help employees manage finances and save for the future. A common point of confusion arises when distinguishing between a 401(k) plan and a Section 125 plan. While both offer significant tax advantages and are sponsored by employers, their primary functions and regulatory frameworks are distinct. This article clarifies the differences and interactions between these two benefit arrangements.

Understanding 401(k) Plans

A 401(k) plan is a qualified retirement savings plan offered by private-sector employers, named after its authorizing Internal Revenue Code (IRC) section. It serves as a long-term savings vehicle, allowing employees to defer a portion of their wages into an investment account for retirement. These plans offer specific tax benefits for building retirement wealth.

Contributions to a 401(k) can come from both the employee and the employer. Employees typically make elective deferrals, which can be either pre-tax or Roth contributions. Pre-tax contributions reduce an employee’s current taxable income, as the money is deducted from their paycheck before federal income taxes are calculated. Roth 401(k) contributions are made with after-tax dollars, meaning they do not reduce current taxable income, but qualified withdrawals in retirement are tax-free.

Employers often contribute to 401(k) plans through matching or profit-sharing contributions. These employer contributions are typically pre-tax and can be subject to vesting schedules. Money in a 401(k) account grows tax-deferred, meaning investment earnings are not taxed until distributed, allowing savings to compound.

Withdrawals from 401(k) plans are intended for retirement. Distributions before age 59½ are typically subject to ordinary income tax and a 10% early withdrawal penalty. Participants must also begin taking Required Minimum Distributions (RMDs) from traditional 401(k)s, usually starting at age 73.

Understanding Section 125 Plans

A Section 125 plan, commonly known as a Cafeteria Plan, is an employer-sponsored benefit program governed by Internal Revenue Code Section 125. Its primary purpose is to allow employees to pay for certain qualified benefits on a pre-tax basis. This arrangement provides employees a choice between receiving cash or selecting from a menu of non-taxable benefits.

The pre-tax mechanism of a Section 125 plan works by deducting the cost of elected benefits from an employee’s paycheck before federal and FICA (Social Security and Medicare) taxes are calculated. This reduces the employee’s gross taxable income. Employers also benefit from reduced payroll tax liabilities.

Common qualified benefits offered through a Section 125 plan include health, dental, and vision insurance premiums, and contributions to Flexible Spending Accounts (FSAs) for healthcare or dependent care. Health Savings Accounts (HSAs) can also be offered. These plans allow employees to use pre-tax dollars for expenses typically paid with after-tax income.

Flexible Spending Accounts (FSAs) under a Section 125 plan are subject to a “use-it-or-lose-it” rule; funds not used by year-end are typically forfeited. However, employers may offer a grace period of up to 2.5 months or allow a limited amount to be carried over to the next plan year. Employers can only offer one of these options, not both.

Distinguishing 401(k) Plans from Section 125 Plans

A 401(k) plan is not a Section 125 plan; they are distinct employee benefit plans with different core purposes and regulatory structures. A 401(k) is designed for long-term retirement savings and investment growth, providing tax-deferred wealth accumulation. In contrast, a Section 125 plan facilitates pre-tax payment for current expenses like health insurance and dependent care.

Their tax treatment highlights these differences. A 401(k) plan offers tax-deferred growth and pre-tax contributions for future use, with taxes paid upon withdrawal (for traditional plans) or tax-free withdrawals (for Roth plans). Section 125 plans provide immediate tax savings by allowing pre-tax payment for current benefit expenses, reducing present taxable income. The types of benefits also differentiate them: 401(k) plans involve retirement contributions and investment accounts, while Section 125 plans manage elections for health benefits, FSAs, and similar welfare benefits.

An important interaction exists where 401(k) contributions can be facilitated through a Section 125 plan. An employer can integrate the option for employees to make pre-tax 401(k) elective deferrals as one of the choices within a broader Section 125 (cafeteria) plan. This allows employees to elect 401(k) contributions via a salary reduction agreement, reducing their gross income for tax purposes.

This administrative convenience means that the employee’s pre-tax 401(k) contribution is processed alongside other pre-tax benefits offered under the Section 125 plan. Despite this, the 401(k) plan retains its separate identity and remains governed by its specific rules as a retirement plan, including contribution limits, investment options, and withdrawal regulations. The Section 125 plan serves as the administrative vehicle that allows the pre-tax election of this retirement contribution, ensuring tax efficiency for the employee.