Issue: President Bush signs new military tax break bill into law

For the week of July 21, 2008

A military bill that both sets forth new tax benefits and extends existing benefits was signed into law in June 2008 by President Bush. The Heroes Earnings Assistance and Relief Tax Act of 2008 ("HEART") provides certain tax benefits and affects 401(k) plans and health flexible spending accounts for active-duty military service personnel and their families.

The HEART Act permits (but does not require) sponsors of Cafeteria Plans with a health flexible spending arrangement to allow participants called to active duty to take distributions of the unused balance in their health flexible spending accounts, instead of mandating forfeiture of unspent monies in those accounts. Now, participants called to active duty may take a distribution of their unused balance to avoid forever losing the contributions. In addition, under the new Act, survivors of those who die during active military duty can put all or part of the death gratuity payments into a tax-deferred savings or retirement plan, even if the contribution puts them over the allowable annual limit. Further, National Guard and reservists can make penalty-free withdrawals from personal retirement plans.

Under HEART, small businesses that employ National Guard and reserve members, and that have agreed to pay the differential between salaries and military pay for employees called to active duty now can receive up to $4,000 in tax credit to offset those payments. Many employers gratuitously provide active duty employees a regular paycheck in the amount of the difference between the employee’s military pay and his or her regular salary. Pre-HEART, this created several administrative issues, as the IRS did not view the differential pay as wages, but rather as supplemental income. Under Section 415 of the Tax Code, a retirement plan may, but is not required to, treat such differential pay as "compensation". The new bill resolves that contradiction.

Now, any payments made by an employer after December 31, 2008 to an employee on active duty for a period of more than 30 days will be treated as "differential wage payments" to the extent the payments represent all or a portion of the wages the individual would have received from the employer absent being called to active military service. Any such payments will be subject to federal withholding rules and will be reportable as W-2 wages. Further, a participant on active duty who is treated as an employee due to receipt of differential wage payments is still entitled to take advantage of the rule allowing for distributions from a qualified plan, 403(b) plan or 457 plan upon commencement of military leave lasting at least 30 days.

The law also would modify the Uniformed Services Employment and Re-employment Rights Act (USERRA) to the extent that an individual who dies or becomes disabled while performing qualified military service will now be viewed as resuming employment in accordance with USERRA on the day preceding death or disability. HEART requires employers to make the applicable amendments to formal retirement plan documents and corresponding summary plan descriptions.