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Compensation Planning & Employee Benefits

Printable Version

Heroes Earnings Assistance and Relief Tax Act (the “HEART” Act)

July 2008

On June 17, 2008, the President signed into law the Heroes Earnings Assistance and Relief Tax Act (the “HEART Act”). The law is designed to provide tax relief to veterans and soldiers, and has several implications for employee health and retirement benefit plans.

Survivor Benefits in Qualified Retirement Plans

The HEART Act requires that qualified retirement plans allow the beneficiaries of plan participants who die while engaged in active military service to receive certain plan benefits. If your plan offers benefits that are contingent on a plan participant dying while still actively employed, such as accelerated vesting or an ancillary life insurance benefit, you must extend these benefits to participants who die while on active duty. Such participants must be treated as if they had returned to work on the day before their death, so that their beneficiaries become entitled to any survivor benefits in your plan. Section 403(b) plans and Section 457 plans maintained by state and local governments must also comply with this rule.

The rule applies to deaths occurring on or after January 1, 2007, and plans must be retroactively amended no later than the last day of the plan year beginning in 2010 (2012 for government plans). If you sponsor a plan that was prepared by Fredrikson & Byron, we will send you a plan amendment for adoption.

Benefit Accruals

The HEART Act allows – but does not require –  plans to go even further, and supply additional benefit accruals to participants who die or become disabled while engaged in active military service.

Currently, the Uniformed Services Employment and Reemployment Rights Act (“USERRA”) provides that certain service members who return to work after their active duty ends must be credited with the benefit accruals or employer contributions they would have earned if they had remained continuously employed during their military service. The HEART Act permits plans to treat participants who die or become disabled while performing active military service in the same manner. You may deem such a participant to have been rehired on the day before the date of death or disability, and then, accordingly, provide him/her with some or all of the benefit accruals that he/she would have been entitled to under USERRA had he/she actually returned to work.

To offer this benefit, however, you must comply with two conditions. First, all participants performing military service must be treated on a reasonably equivalent basis. In other words, you may not discriminate in favor of highly compensated employees.

Second, if a plan benefit is contingent on employee contributions or elective deferrals, you must determine the benefit by looking at the average of the contributions or deferrals actually made by the participant during the twelve months prior to military service, or, if less, the length of time he/she was employed.

This optional provision can be applied to deaths and disabilities occurring on or after January 1, 2007.  If you sponsor a plan that was prepared by Fredrikson & Byron and you wish provide for these additional accruals, you will need to advise us of your desire to do so so that we may prepare the appropriate amendment.

Differential Wages

The HEART Act also makes changes to the definition of compensation as it relates to voluntary wages paid by employers to employees actively serving in the military. Specifically, it provides that “differential wage payments” must be considered compensation for withholding, retirement plan, and IRA purposes. A “differential wage payment” is any payment made by an employer to an employee who is performing active military service that represents all or some of the wages that the employee would have received from the employer if he/she were still actively employed. Under this new rule, differential wage payments are subject to income tax withholding. Additionally, employees may make contributions to a retirement plan from differential pay or become entitled to additional benefits under the plan on the basis of differential pay.

Not all employers pay differential wages to employees called to active duty, and the Act does not require you to do so. However, if you do, you must make differential wage payments available to all your employees on reasonably equivalent terms. Additionally, employees must be entitled to make contributions based on differential wages on reasonably equivalent terms.

For withholding purposes, this provision is effective for wages paid on or after January 1, 2009. For retirement plan and IRA purposes, it is effective on the first day of the plan year beginning in 2009. Plans must be retroactively amended by the last day of the plan year that begins in 2010 (2012 for government plans). If you sponsor a plan that was prepared by Fredrikson & Byron, we will send you a plan amendment for adoption.

Because the burden this provision places on small employers may discourage them from offering differential wage payments, the Act provides them with some temporary incentive. If you employ fewer than fifty employees, you may be entitled to a tax credit of up to 20% of the differential wage payments you make to “qualified employees” – those who have been employed for ninety-one or more days prior to the differential wage payment. However, if you take the credit, you may not also take a deduction for compensation up to the amount of the credit. The provision also requires that you have a written plan in place. We expect some guidance from the IRS on what would constitute a “written plan,” since generally wage payments would not require a plan.

The small employer tax credit can be taken for wages paid on or after January 1, 2009, but the provision expires on December 31, 2009.

Distributions from Section 401(k), 403(b), and 457 Plans

Under the HEART Act, certain plan participants who are called to active duty may elect to receive distributions from their 401(k) plans. Generally, an employee cannot receive such a distribution while still actively employed. Accordingly, the Act provides that if employees are on active duty for a period of more than thirty days, their employment is considered severed, thus permitting a distribution. As a result, the employees can take 401(k) distributions, but if they choose to do so, they cannot make any elective contributions for six months after the date of the distribution. 

This rule also applies to Section 403(b) and Section 457 plans. Plans must begin complying with the rule in the plan year beginning in 2009. Retroactive amendments must be adopted no later than the last day of the plan year that begins in 2010 (2012 for government plans). Again, if you sponsor a plan that was prepared by Fredrikson & Byron, we will send you a plan amendment for adoption.

Penalty-Free Withdrawals from Retirement Plans

The HEART Act also provides that certain active duty reservists may make penalty-free withdrawals from their retirement plans. Typically, employees who receive distributions from retirement plans prior to age 59 1/2, death, or disability are subject to a 10% early withdrawal tax. The Act makes permanent an expired provision of the Pension Protection Act of 2006 (PPA), which provided that the early withdrawal tax does not apply to a “qualified reservist distribution.” A qualified reservist distribution is one made to a reservist called to active duty for 180 or more days (or for an indefinite period) from a 401(k) plan, Section 403(b) plan, or other similar arrangement. The employee may repay the amount withdrawn to an IRA within two years of the last day of active duty, without regard to otherwise applicable limits on IRA contributions.

This provision is effective on January 1, 2008, the date it expired under the PPA.

Cafeteria Plan Withdrawals

Another key, but optional, provision of the HEART Act protects reservists from forfeiting balances in their health FSA accounts when they are called to active duty. Plan participants generally must use the amounts in their health FSA accounts for medical expenses incurred within the plan year (plus a grace period), or forfeit those amounts. The HEART Act creates an exception to this use-it-or-lose-it rule for “qualified reservist distributions.” Plans can permit reservists who are called to active duty for at least 180 days (or an indefinite period) to withdraw amounts in their health FSA accounts without penalty, provided they do so after the call to active duty and before the last day of the coverage period of the FSA that includes the date of the call to active duty.

This optional provision is effective for distributions taken on or after June 17, 2008.  Please contact your cafeteria plan provider or us (if we prepared your plan) if you wish to add this optional provision.

Military Death Benefit Gratuity and Servicemembers’ Group Life Insurance Rollovers

The HEART Act also allows an individual who receives a military death benefit gratuity or the proceeds of Servicemembers’ Group Life Insurance policy to roll those amounts over into a Roth IRA or Coverdell Education Savings Account (ESA). The rollovers may be done without regard to the contribution limits otherwise applicable to Roth IRAs or Coverdell ESAs. This provision is effective for deaths occurring on or after October 7, 2001. However, the rollovers must be done within a year of receipt of the death benefit, or, if later, by June 17, 2009.

Mental Health Parity

Finally, in a provision extending to all employees, the HEART Act renews the mental health parity requirements that had expired under the Internal Revenue Code, ERISA, and the Public Health Service Act (PHSA). If you sponsor a group health plan, you do not have to provide mental health benefits. However, under the requirements, if you do offer mental health benefits, you cannot subject them to lifetime or annual dollar limits that are not imposed on other medical and surgical benefits.  (You can treat mental health benefits differently in other ways, though; for example, you can provide for limits on the amount of visits or number of days of inpatient stays that will be eligible.) A plan that violates the mental health parity requirements is generally subject to an excise tax of $100 each day the plan is noncompliant.

These mental health parity requirements had expired on December 31, 2007. They are effective under the HEART Act on June 17, 2008, but are set to expire again on December 31, 2008.

If you have any questions on the HEART Act or its impact on your plan, please contact a member of our Compensation Planning & Employee Benefits Group.