Understanding Section 128 Account Contribution Programs

New Proposed Regulations Clarify Section 128 Accounts

Recent proposed regulations (REG-101355-26) from the Internal Revenue Service (IRS) provide significant guidance on the operation of employer-sponsored Section 128(c) account contribution programs. While these regulations are proposed and apply to plan years starting on or after the date final rules are published, taxpayers are permitted to rely on them for current and past plan years ^[1]. These accounts offer a tax-advantaged way for employees to receive employer contributions or make their own pre-tax contributions for certain expenses.

Overview of the Provision

Under Internal Revenue Code (IRC) Section 128(c), an employer can contribute up to $2,500 annually to an employee's designated account or an account for their dependent ^[2]. This amount is excluded from the employee's gross income. This $2,500 annual limit applies per employee across all dependents and employers. If contributions exceed this amount, the employee must include the excess in their gross income for that tax year. For example, if an employee works for two employers, each offering a Section 128(c) program, the total tax-free employer contribution to their or their dependents' accounts across both jobs cannot exceed $2,500. This $2,500 employer contribution also counts towards a larger overall annual limit of $5,000 for these types of accounts. Both the $2,500 and $5,000 limits are scheduled to be indexed for inflation for plan years beginning after 2027.

Pre-Tax Employee Salary Reduction

Employees can also contribute to these accounts on a pre-tax basis through a salary reduction arrangement established under a Section 125 cafeteria plan ^[3]. This means that the amount an employee elects to contribute is deducted from their gross salary before income taxes are calculated, effectively reducing their taxable income. A key distinction, as outlined in the proposed regulations, is that this pre-tax salary reduction option is only available for contributions directed to a dependent's Section 128 account, not to an account established for the employee themselves ^[4]. This provision allows employees to leverage their own pre-tax earnings to save for eligible dependent expenses.

Payroll Tax Implications

While employer contributions to Section 128 accounts are excluded from an employee's federal income tax, they are not exempt from all federal taxes. Amounts excluded from income under Section 128(a) remain subject to Social Security, Medicare (FICA taxes), and federal unemployment taxes (FUTA) ^[5]. However, these contributions are not subject to federal income tax withholding. This means that while employees benefit from reduced income tax liability, the employer and employee continue to pay FICA and FUTA taxes on these amounts.

Eligibility for Self-Employed Individuals

Certain self-employed individuals are generally not permitted to participate in Section 128(c) account contribution programs. This includes partners in a partnership, sole proprietors, directors serving exclusively as directors, and 2-percent shareholders of S corporations, as defined by IRC Section 1372(b) ^[6]. These individuals are typically considered owners rather than common-law employees for benefit plan purposes. However, these self-employed individuals may still establish and maintain such a program for their common-law employees, even if they cannot personally participate. Conversely, a shareholder-employee of a C corporation is considered a common-law employee and is eligible to participate in a Section 128(c) program.

Limits for Multiple Employers or Spouses

The $2,500 annual limit is applied per employee. If an employee works for more than one employer, the combined contributions across all employers to their or their dependents' accounts cannot exceed $2,500 tax-free. Any excess must be reported as gross income by the employee. Employers offering these programs must ensure their plan prohibits contributions that exceed this limit for an individual employee. When it comes to spouses, each spouse can independently direct contributions of up to $2,500 to the same child's account, totaling up to the $5,000 overall annual limit if both spouses participate. For tax purposes, a dependent is generally defined as an individual an employee expects to claim under IRC Section 152 ^[7]. For divorced or separated parents, or those filing separately, only the parent who can claim the child as a dependent can direct a Section 128 account contribution for that child.

Nondiscrimination Rules

Section 128 account contribution programs must comply with nondiscrimination rules to ensure they do not disproportionately favor highly compensated employees (HCEs) or their dependents ^[8]. A program satisfies this requirement if it provides benefits on the same terms to all eligible employees. Eligibility classifications must be objective and based on reasonable business criteria, such as job categories, compensation structure (e.g., salaried or hourly), or geographic location. Classifications that essentially name specific individuals are not considered reasonable. If a program fails the nondiscrimination tests, only the HCEs lose the tax exclusion; non-HCEs can still benefit from the program.

Pilot Program Matching Contributions

Some employers may offer matching contributions for amounts provided under pilot programs, such as those related to Section 6434. The proposed regulations introduce a safe harbor for these "pilot match contribution arrangements," exempting them from some of the standard nondiscrimination requirements. For instance, if an employer contributes $1,000 as a pilot program match to a dependent's Section 128 account, and the employee also contributes $2,500 via a Section 125 cafeteria plan, the total employer contribution of $1,000 falls under the $2,500 exclusion limit for employer contributions. If the employer also makes another contribution, say $1000, then the employer would need to designate $2,500 as a Section 128(c) contribution and treat any excess, such as an additional $1,000, as a non-Section 128(c) contribution, which would then be included in the employee's gross income and wages.