A pre-tax contribution is pay an employee routes into a plan before federal income tax is applied to it, so the amount never reaches taxable wages for the year. The tax on it is deferred rather than forgiven, and it is collected later when the money comes out.
What almost every explanation of this skips is that pre-tax is a category rather than a rule. Two contributions can both be pre-tax for income tax and be treated in opposite ways for payroll tax, and the difference shows up on the same paycheck.
The Payroll Tax Split
A 401(k) elective deferral escapes income tax and does not escape FICA. Nothing in any paragraph of the FICA wage exclusion list, other than the wage base cap, excludes an employer contribution under a qualified cash or deferred arrangement to the extent it is not included in gross income, or a designated Roth contribution (26 U.S. Code section 3121(v)(1)(A)). The consequence for a payroll register, and how the W-2 boxes then disagree, is worked through in gross wages.
A salary reduction into a cafeteria plan behaves differently. The FICA definition of wages does not include a payment made under a cafeteria plan within the meaning of section 125 if the payment would not be treated as wages without regard to the plan, and it is reasonable to believe that section 125 would not treat any wages as constructively received (26 U.S. Code section 3121(a)(5)(G)).
So the health premium an employee pays by salary reduction leaves the Social Security and Medicare base, and the retirement deferral sitting two lines below it on the same stub does not. What a cafeteria plan may and may not offer is set out in cafeteria plan.
The income tax exclusion behind the cafeteria side is its own rule. No amount is included in the gross income of a participant in a cafeteria plan solely because the participant may choose among the benefits of the plan (26 U.S. Code section 125(a)).
The Ceiling Is Statutory, and It Moves
Elective deferrals are included in the individual’s gross income to the extent they exceed the applicable dollar amount for the taxable year, and that sentence does not apply to the portion of the excess that does not exceed the individual’s designated Roth contributions for the year (26 U.S. Code section 402(g)(1)(A)). The applicable dollar amount written into the statute is $15,000 (26 U.S. Code section 402(g)(1)(B)).
That figure is not the number anybody uses. For taxable years beginning after December 31, 2006 the Secretary adjusts the $15,000 amount at the same time and in the same manner as under section 415(d), with a base period of the calendar quarter beginning July 1, 2005, and any increase that is not a multiple of $500 is rounded to the next lowest multiple of $500 (26 U.S. Code section 402(g)(4)).
Two working consequences follow. The live limit comes from the annual IRS announcement rather than from the Code, so a limit quoted from memory is a stale limit. And the rounding runs downward, which is why the number moves in $500 steps and sometimes does not move at all.
When the Ceiling Is Breached
The statute builds in a repair, and it is on a clock rather than on a form.
Not later than the first March 1 following the close of the taxable year, the individual may allocate the excess deferrals among the plans they were made under and notify each plan of the portion allocated to it. Not later than the first April 15 following the close of the taxable year, each plan may distribute to the individual the amount allocated to it, together with any income allocable to it through the end of that taxable year, and that distribution may be made notwithstanding any other provision of law (26 U.S. Code section 402(g)(2)(A)).
The tax result rewards acting in time. A distribution to which that subparagraph applies is not included in gross income, except that any income on the excess deferral is treated as earned and received in the taxable year in which it is distributed (26 U.S. Code section 402(g)(2)(C)).
The excess itself was already taxed by paragraph (1), so the correction takes out the money without taxing it a second time. Miss April 15 and that clean route is gone.
The common case is an employee who changed jobs mid-year. The limit is written against the elective deferrals of any individual (26 U.S. Code section 402(g)(1)(A)), while each plan sees only its own, so the individual is the only party looking at the combined figure.
Pre-Tax, Roth, and After-Tax Are Three Things
Pre-tax reduces this year’s taxable wages and taxes the whole distribution later. A designated Roth contribution is included in wages now and can deliver the earnings tax free on a qualified distribution. An ordinary after-tax contribution is included in wages now, creates basis, and never gets tax-free treatment on its earnings. The basis mechanics and the qualified distribution conditions are set out in after-tax contributions.
Common Questions
An employee’s 401(k) or 403(b) elective deferral, and a salary reduction into a cafeteria plan for health premiums or a health flexible spending arrangement. Both cut taxable wages for the year, and only the second one also cuts the Social Security and Medicare base (26 U.S. Code sections 3121(v)(1)(A) and 3121(a)(5)(G)).
An elective deferral does not, because nothing in the FICA exclusion list takes it out of wages (26 U.S. Code section 3121(v)(1)(A)). A cafeteria plan salary reduction does, because such a payment is outside the FICA definition of wages in the first place (26 U.S. Code section 3121(a)(5)(G)).
Not mechanically. A pre-tax contribution never enters taxable wages, so there is nothing left to deduct on the return, and the W-2 figure the return starts from already excludes it, which gross wages works through. The relief has already happened in payroll.
The excess is included in gross income under section 402(g)(1), and the statute gives an allocation step by March 1 and a distribution step by April 15 to take the money back out without taxing it again (26 U.S. Code section 402(g)(2)).
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