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What’s The Story? Part 2

By Jack Towarnicky

Betcha Didn’t Know That America’s Most Valuable Benefits Tax Preference is Celebrating Its 40th “Birthday” This Year

No, it isn’t 401(k) – Internal Revenue Code Section 401(k) (IRC §401(k)).
I took my first corporate benefits position at Marathon Oil in Findlay, Ohio back in 1979. I had modest experience with the benefits industry as it existed prior to the Revenue Act of 1978.1 Given all the hoopla surrounding the 40th anniversary of Congress adding §401(k) to the tax code (I tracked 100+ articles about the 40th birthday/anniversary of the 401(k)), my bet is most of today’s benefits media also started reporting after 1978.2

Yes, it is IRC §125.
125, what’s that? IRC §125 was also added by the Revenue Act of 1978.3 An internet search revealed zero articles, that’s none, on IRC §125 to celebrate its 40th birthday/anniversary. IRC §125 allows plan sponsors to create cafeteria plans. A cafeteria plan enables active employees the opportunity to contribute on a pre-tax basis towards the cost of certain welfare benefits or to pay insurance premiums for:

  • Employer-sponsored medical, dental, vision, hearing, accident and disability coverages, and 
  • Health care and dependent day care flexible spending accounts, or 
  • Contributions to health savings accounts. 

More Valuable Than the 401(k)?
Yes. When first introduced, deferrals under IRC §401(k) were pre-tax (and tax free) for Social Security (FICA) and Medicare Hospitalization (FICA-Med) taxes. Once Congress noticed the impact on tax revenues, they flipped 401(k) contributions to a post-tax basis for Social Security and Medicare taxes.4 So, since 1984, 401(k) deferrals have been taken on an after-tax basis for purposes of FICA and FICA-Med.

However, §401(k) deferrals have always been just that, deferrals of federal and most state income taxes. Bottom line, worker contributions to a §401(k) plan aren’t tax free. They are only tax deferred for income tax purposes and will someday become part of your taxable income. So, depending on changes in marginal income tax rates, IRC §401(k) deferrals may increase a worker’s federal and/or state income taxes.

For comparison, a worker’s cafeteria plan contributions per IRC §125 are pre-tax and tax free for federal and most state income tax purposes, and for Social Security (FICA) and Medicare Hospitalization Insurance (FICA-Med) purposes.

IRC §125 - Not tax deferred, and ultimately taxable – but, pre-tax and tax free!

Saving for Retirement?

If you want to save for retirement and obtain the maximum tax preference, ask your plan sponsor to adopt a Health Savings Account-capable health care plan in addition to the 401(k) (or 403(b) or 457(b) plan). Otherwise, you’re missing out on the best 40th birthday/anniversary benefits celebration!

1Section 135, Pub.L. 95–600, enacted 11/6/78, Accessed 12/11/18 at:  
2Examples include:  NPR, The 401(k) Turns 40, 11/9/18, Accessed 12/11/18 at:; See also:  S. Max, The 401(k) Is Turning 40. We Looked at the Good, the Bad, and the Future, Barrons, 11/19/18, Accessed 12/11/18 at:; See also:  W. Birdthistle, D. Hemel, The 401(k) Is Turning 40 Years Old. It’s Past Time We Change How Americans Save for Retirement, Time Magazine, 11/2/18, Accessed 12/11/18 at:; See also:  L. Lucas, The 401(k) Plan Turns 40:  Six Lessons from 1978, December 2017, Accessed 12/11/18 at:; See also:  N. Adams, The Birth of a Notion, 11/6/18, Accessed 12/10/18 at:  
3Note I, Supra, Section 134.    
4Section 324(a)(1) of The Social Security Amendments of 1983, Pub.L. 98–21, 4/20/83 amended IRC §3121 to include 401(k) deferrals as part of gross income for FICA wage purposes.  Accessed 12/11/18 at: 

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