If the employee declines medical coverage, then he/she receives a cash credit. This credit cannot be taken as income but must go into the employee's 401(k) account.

Is that a valid design for a 125 plan given that the employee does not have the option of taking it as cash?

Also, do these contributions count against the employee's $10,000 annual deferral limit?

A cafeteria plan may include a 401(k) option only if it also has a cash-out option.