On June 17, 2008, the Heroes Earning Assistance and Relief Tax Act of 2008 (HEART) (Pub. L. 110-245) was signed into law by the President. The HEART Act deals principally with the tax treatment of military personnel, with provisions applying to a wide range of Internal Revenue Code (“Code”) provisions. This article will deal primarily with those provisions which have an effect on qualified retirement or Section 125 plans, and IRAs.
Death and Disability Benefits while under USERRA-Qualified Military Service
Plan Qualification Requirement: Additional Death Benefits
Section 104(a) of the HEART Act adds a new paragraph (36) to Section 401(a) of the code, requiring a tax qualified plan to provide that in the event a participant dies while performing “qualified military service” (as defined in the Uniformed Services Employment and Reemployment Rights Act of 1994 (“USERRA”)), that participant must be treated as if he or she had resumed employment and then terminated employment on account of death. The participant’s survivors would then be entitled to any additional benefits that would otherwise be provided in the case of a participant who died while actively employed. Additional benefits, in this case, include benefits such as accelerated vesting, ancillary life insurance benefits, and any other benefits that are conditioned on the participant’s death, but do not include benefit accruals relating to the participant’s period of qualified military service. Conforming amendments made by Sections 104(c) of the HEART Act extend this requirement to Section 403(b) plans and Section 457 governmental plans, and add this requirement as a condition to the deduction timing rule of Section 404(a)(2) of the Code.
This provision is effective for deaths occurring on or after January 1, 2007. Plans must be amended to comply with the provision by the last day of the first plan year beginning on or after January 1, 2010 (January 1, 2012 for governmental plans). This extended remedial amendment period is available only if the plan has been operated in accordance with the requirement beginning as of the effective date.
Optional Benefit Accruals for Death or Disability
Section 104(b) of the HEART Act provides that a retirement plan qualified under Sections 401(a), 403(b) or 457 of the Code may (but is not required to) treat an employee who leaves employment with the sponsoring employer for qualified military service and cannot be reemployed because of either death or disability (as defined in the plan), as if the individual had been reemployed on the day preceding death or disability and terminated employment because of death or disability. The employer would then be allowed to make contributions or additional benefit accruals on behalf of that individual as if he or she had survived and returned to employment. The amount of employee contributions and/or deferrals would be determined on the basis of the employee’s actual contributions or deferrals for the 12-month period of service immediately prior to the beginning of the individual’s qualified military service or, if the individual had been employed for less than 12 months, the full length of the employee’s continuous service with the employer. If an employer elects to apply these rules, all similarly situated individuals must be credited with service and benefits on a reasonably equivalent basis.
A plan may apply these rules for deaths or disabilities occurring on or after January 1, 2007, or as of any later date. If these rules are applied, the plan must be amended by January 1, 2010 (January 1, 2012 for governmental plans), subject to the rules for the extended remedial amendment period as set forth above.
Differential Military Pay Treated as Wages
At present, differential pay (generally, the difference between the employee’s military compensation and the amount of compensation the employee would have received from the employer during the same period) is not treated as wages for federal income tax purposes, and must be reported by an employer on a Form 1099. Section 105 of the HEART Act amends Section 3401 of the Code to provide that if an employer pays differential pay to an employee during a period of service in the uniformed service lasting more than 30 days, that:
- differential pay must be reported as wages on the employee’s W-2;
- the individual receiving the differential pay will be treated as an employee of the employer; and
- the differential pay will be treated as compensation for both qualified plan and IRA purposes.
The employee will, therefore, be able to make contributions to a qualified plan or an IRA based on this compensation.
This provision is effective for differential pay paid after December 31, 2008. Plans must be amended to comply with these provisions by the last day of the first plan year beginning on or after January 1, 2010 (January 1, 2012 for governmental plans).
Withdrawals from Qualified Plans and IRAs
- Military Service Treated as Severance from Employment
Section 105 of the HEART Act also provides that, effective for plans years beginning after December 31, 2008, an individual performing service in the uniformed service for a period of more than 30 days will be treated as having severed from employment. The limitations on inservice distributions of tax-deferred contributions will, therefore, not apply. However, if an individual takes such a distribution, he or she will be barred from making elective deferrals or employee contributions during the 6-month period beginning on the date of distribution.
- Ability to Withdraw Elective Deferrals without Penalty
The Pension Protection Act of 2006 amended Section 72(t) of the Code to provide that a “qualified reservist distribution” would not be subject to the 10% penalty on early withdrawals. A qualified reservist distribution is a distribution of a reservist’s elective deferrals from a 401(k) or 403(b) plan, or an IRA, made to a reservist who was called to active duty after September 11, 2001, and before December 31, 2007 for a period in excess of 179 days (or for an indefinite period), if the distribution is made while the reservist is on active duty. Section 107 of the HEART Act makes the exemption from the penalty tax permanent for all individuals called to duty on or after December 31, 2007.
Individual Retirement Accounts
- Rollover of Death Benefits to Roth IRA
Section 109 of the HEART Act amends Sections 408A and 530 of the Code to provide that a beneficiary who receives a military death gratuity or a payment from the Servicemembers’ Group Life Insurance (“SGLI”) program may contribute up to the full amount of the gratuity or SGLI payment to one or more Roth IRAs or Coverdell education savings accounts, regardless of the contribution limitations otherwise applicable to those accounts (i.e., the annual contribution limit and the income phase-out of the contribution dollar limit). The contribution will be treated as a qualified rollover contribution to the account. This special treatment applies if the contribution is made within one year of the date the beneficiary receives the gratuity or SGLI payment. In the event of a subsequent distribution from the Roth IRA or Coverdell education savings account that is not a qualified distribution, the amount of the distribution related to the gratuity or SGLI payment is treated as nontaxable investment in the contract.
This provision is generally effective for payments made with respect to death from injuries occurring on or after June 17, 2008, except that this special treatment is also available for payments made with respect to death from injuries resulting from an injury occurring on or after October 7, 2001, as long as the contribution to the account is made no later than June 17, 2009.
- Ability to Withdraw Elective Deferrals without Penalty
A “qualified reservist distribution” made to reservist from an IRA will be exempt from the 10% penalty tax subject to the same conditions set forth above for distributions from 401(k) and 403(b) plans.
Tax Rules on Expatriation of Individuals
Title III of the HEART Act also contains provisions imposing a new tax on some US citizens who give up their US citizenship, and some long-term residents who give up their US residency. The core of this provision is that expatriation is regarded as resulting in a “deemed sale,” and the expatriated individual is subject to a tax on the gains from that sale in excess of $600,000 (to be adjusted for inflation). While this new tax does not, on the whole, directly affect retirement plans, there are separate provisions that apply to “deferred compensation items.” A deferred compensation item is, generally, any interest in a plan or arrangement described in Section 219(g)(5) of the Code. Plans or arrangements described in Section 219(g)(5) of the Code are:
- plans qualified under Section 401(a) of the Code;
- 403(b) plans;
- annuity plans described in Section 403(a) of the Code;
- governmental deferred compensation plans (with the exception of eligible deferred compensation plans (within the meaning of Section 457(b) of the Code)); and
- SEPs and Simple IRAs.
Also included as deferred compensation items are any interest in a foreign pension plan, any nonqualified deferred compensation, or any right to property which has not been previously been taken into account under or taxed under Section 83 of the Code.
Withholding on “Qualified Deferred Compensation Items”
The HEART Act requires an employer to withhold 30% of any payment that is payment from a “qualified deferred compensation item.” A qualified deferred compensation item is any deferred compensation item with respect to which:
- the payor (employer) is either a US person or a person who elects to be treated as a US person for the purposes of income tax withholding; and
- the expatriate notifies the payor of his status as a covered expatriate and irrevocably waives any claims for a reduction in the amount of withholding under any treaty with the US.
If the deferred compensation item is not a qualified deferred compensation item, and is not subject to Section 83, it will be treated as having been received on the day before the expatriation date. If the item is subject to Section 83, it will be treated being transferable and no longer subject to a substantial risk of forfeiture on the date before the expatriation date. Adjustments will be made to subsequent distributions to reflect the foregoing treatment.
Treatment of Other Individual Accounts
If the expatriate maintains an IRA, a health savings account, an Archer MSA, a Section 529 qualified tuition plan, or Coverdell education savings account, that expatriate is treated as receiving a distribution of his entire interest in those accounts on the day before the expatriation date. Adjustments will be made to subsequent distributions to reflect this treatment.
Distributions from Health Flexible Spending Accounts
Section 114 of the HEART Act amends Section 125 of the Code to permit health flexible spending accounts (“health FSAs”) to provide for “qualified reservist distributions” of unused health FSA balances to reservists who are called to active duty and who may be unable to use up the funds they have contributed prior to the end of the year. This new provision is an exception to the “use-it-or-lose-it rule,” which mandates the forfeiture of an employee’s health FSA account balance at the end of a plan year and related grace period, if any, if the employee fails to use up the full amount he or she contributed.
A qualified reservist distribution is a distribution made to a participant-reservist who is called to active duty for a period of more than 179 days of “all or a portion of the balance in the employee’s account.” We assume that “balance in the employee’s account” means the total amount contributed to the account by the employee (rather than the amount the reservist had elected to contribute for the plan year) minus the amount of any prior reimbursements. The distribution must be made at any time during the period from the date the reservist was called to active duty and the last date that reimbursements could otherwise be made by the health FSA for that plan year. In other words, the distribution must be made as of the last day of the plan year or related grace period, if any. To the extent that the health FSA provides for a run-out period, it appears that a qualified reservist distribution may be made as of the last day of the run-out period.
Because contributions to a health FSA are wages and the HEART Act does not address the taxability of qualified reservist distributions, we presume that such distributions will be taxable to the participant.
Because this provision is optional, plan sponsors must decide if they wish to amend their plans to include it. If the plan sponsor decides to do so, the amendment may apply to qualified reservist distributions made as early as June 17, 2008.
Parity of Mental Health Benefits
In the most recent of a series of extensions of the provisions of the Mental Health Parity Act of 1996, Title IV of the HEART Act extends those mental health parity requirements through December 31, 2008.