No, that's the output from the internal amplifier or "sound card" as you call it.
I'm talking about using the larger rectangular hole at the bottom, where a charger plugs in and where you interface to a PC or Mac to transfer data or use iTunes. There are many third-party devices which allow you to use this interface to obtain line-level output. The data is read directly from the internal hard drive, therefore the sound is not modified by the internal amplifier. It is line level. Feeding this to a stereo (home, car, whatever) is the same as feeding it a CD player. That's why the quality of the encoding can make a difference.
If you're just listening over crummy stock iPod ear buds, then I agree, it doesn't much matter whether you're listening to 128k mp3's or to lossless because it's gonna sound like crap anyway. But I use my iPod more as my "portable library" and fill it with the 256k or 320k if I can find it, because when I play back in my car or at home, it's a line level signal.