Employee Benefits Taxation and Tax Treatment
The Core Principle
Employer-provided benefits are generally deductible to the employer and excludable to the employee only when a specific Code provision allows exclusion. Otherwise, the value is includible in gross income. Candidates must know the exclusion provisions: 105 and 106 for employer-provided health coverage, 125 for cafeteria plans, 129 for dependent care assistance, 127 for educational assistance, and 132 for fringe benefits.
Qualified Plan Taxation
Contributions to qualified plans are generally deductible, and employees are not taxed until distribution. Distributions are taxed as ordinary income except for designated Roth distributions, which are tax-free if qualified. Early distributions before age 59 1/2 generally incur a 10 percent additional tax unless an exception applies.
Common Traps
- Assuming all fringe benefits are excludable; only specific statutory exclusions apply.
- Confusing the taxation of employer contributions with the taxation of earnings.
- Forgetting that life insurance protection in a qualified plan creates imputed income under Table I.
- Missing the distinction between a Roth contribution and a Roth conversion.
Worked Example
An employer pays $6,000 of health premiums for an employee. The employer deducts the cost, and the employee excludes the value under sections 105 and 106. If the same employer instead pays $6,000 of cash, it is fully taxable wages. The exclusion depends on the statutory provision, not the employer's intent.
Rule of Thumb
Ask: Is there a specific exclusion? If not, the benefit is taxable. Then ask when the tax is triggered: at contribution, at vesting, or at distribution.