The Heroes Earnings Assistance and Relief Tax Act of 2008 (the “HEART Act”) (also known as the “HEROES Act”) is an eclectic piece of legislation enacted on June 19, 2008, containing provisions impacting tax-qualified plans, health and welfare plans, as well as having a host of tax incentives that benefit military personnel and their families. The HEART Act provides for retirement plan survivor and disability benefits, qualified reservist distributions from tax-qualified plans, death gratuities and life insurance payments to military spouses and provides a broad range of tax provisions with respect to military and certain first responders and US Peace Corp. volunteers. Some of the provisions provided under the HEART Act are mandatory and, therefore, plans must be amended to comply, while other provisions are voluntary. Those provisions that are mandatory must be adopted by the last day of the first plan year beginning on or after January 1, 2010. However, a plan will be treated as operating under the terms of the HEART Act as long as the plan is amended retroactively and operated in accordance with the amendment from its effective date. Optional provisions must be adopted by the last day of the plan year in which the plan sponsor elects to provide for such provision(s).
This article is not meant to be exhaustive of all issues under the HEART Act, but will concentrate on the major provisions of the HEART Act that affect retirement plans and health and welfare plans (specifically health care flexible spending accounts (FSAs)).1
The Uniformed Services Employment and Reemployment Rights Act (“USERRA”)2 required qualified plans to provide employees who returned to work after a period of “qualified military service,” as defined in USERRA, and who met certain requirements, to receive credit for benefit accruals under a defined benefit plan, or employer contributions under a defined contribution plan, which they would have received had they been employed during the period of “qualified military service.” The HEART Act expands on these provisions in the following ways:
Treatment of Differential Military Pay as Wages
Prior to the enactment of the HEART Act, USERRA required that payments made by an employer that made up the difference between military pay and an employee’s normal pay (“differential wage payments,”3 ) for those employees on active duty in the military for a period of more than 30 days, were not considered wages from the employer for the purpose of income tax, social security, FICA, FUTA and similar withholdings, and were treated as “compensation” under a tax-qualified retirement plan, only if the plan so provided. The HEART Act changed this, so that effective on and after January 1, 2009, differential wage payments, if provided for by an employer, must be included as wages (and therefore reported on Form W-2), and treated as “compensation” for purposes of benefit accruals under any plan subject to USERRA.
For example, under a 401(k) plan, an employee who is on active duty for a period of more than 30 days and receives differential wage payments from his employer may continue to make elective deferrals from the differential wage payments and receive matching contributions, if applicable. Contributions made by an employee from differential wage payments to a 401(k) plan will limit the amount of contributions the employee may be able to make in the year he or she returns to employment.
Even though, under USERRA, employers are not obligated to make differential wage payments, once they do so, the above HEART Act provision with respect to any retirement plan becomes mandatory.
Qualified Reservist Distributions
Under current law, a taxpayer who receives a distribution from a qualified retirement plan prior to age 59½, death or disability, generally is subject to a ten percent (10%) early withdrawal tax on the amount included in income, unless an exception to this tax applies. Among other exceptions, the early distribution tax does not apply to distributions made to an employee who separates from service after age 55, or to distributions that are part of a series of substantially equal periodic payments made for the life (or life expectancy) of the employee or the joint lives (or life expectancies) of the employee and his or her beneficiary (e.g., annuities).
Amounts held in a 401(k) plan generally may not be distributed before severance from employment, age 59½, death, disability or financial hardship of the employee.
The Pension Protection Act of 2006 (“PPA”) amended Section 72(t) of the Internal Revenue Code of 1986, as amended (the “Code”), to waive the ten percent early withdrawal tax on a “qualified reservist distribution.” For this purpose, PPA defines a “qualified reservist distribution” to be a distribution: (i) from an individual retirement account (“IRA”) or attributable to elective deferrals under a 401(k) plan, among other similar arrangements; (ii) is made to an individual who by reason of being a member of a reserve component of the military was ordered or called to active duty for a period of more than 180 days or for an indefinite period and (iii) that is made during the period beginning on the date of such order or call to duty and ending at the close of the active duty period. Neither PPA, nor the Technical Explanation of HR-6081 with respect to the HEART Act (the “Committee Report”), address whether a reservist can withdraw all or just a portion of his or her elective deferrals as a qualified reservist distribution. Also, unlike in the case of a hardship distribution from a qualified plan, there is no requirement that the reservist first receive all available loans and other available distributions under such plan. Importantly, effective January 1, 2009, a reservist who takes a qualified reservist distribution is barred from making elective deferrals to the plan for six months from the date of the qualified reservist distribution. Qualified reservist distributions do not violate the distribution restrictions otherwise applicable to a 401(k) plan.
Under PPA, the special rules applicable to a qualified reservist distribution apply to individuals ordered or called to active duty after September 11, 2001 and before December 31, 2007. The HEART Act removed the December 31, 2007 “sunset” date, making this provision permanent.
In addition, an individual who receives a qualified reservist distribution may, at any time during the two-year period beginning on the day after the end of the active duty period, re-contribute the distributed amount to an IRA, but not into a tax-qualified plan. However, as a concession, the dollar limitations otherwise applicable to contributions to an IRA (i.e., US$5,000, or, if older than age 50, US$6,000) do not apply to contributions made pursuant to the repayment of a qualified reservist distribution. Therefore, a reservist may repay the entire amount that he or she had taken as a qualified reservist distribution, provided the two-year period requirement is met.
The HEART Act provides a new tax qualification requirement for a tax-qualified retirement plan under Section 401(a) of the Code. Under the new requirement, in order for a plan to remain qualified, it must provide that, in the case of a participant who dies while performing qualified military service, the survivors of the participant must be entitled to any additional benefits (other than benefit accruals relating to the period of qualified military service) that would be provided under the plan, had the participant resumed employment with the employer the day before death and then terminated employment on account of death. Therefore, for example, if a plan provides for accelerated vesting, ancillary life insurance benefits or other survivor benefits that are contingent upon a participant’s termination of employment on account of death, the plan must provide such benefits to the beneficiary of a participant who dies during qualified military service.
Benefit Accruals Upon Death or Disability
USERRA governs certain benefits for employees returning from military duty, and provides that returning employee’s military service is considered to be employment for benefit accrual purposes. The HEART Act permits, but does not require, a plan to treat an employee who dies or becomes disabled while on a qualified military leave and, therefore cannot be reemployed, as if he or she had resumed employment on the day before his or her death or disability. Moreover, for benefit accrual purposes, the HEART Act permits, but does not require, an employer to treat an employee who dies or becomes disabled in military service as though he or she had worked until his or her date of death or disability. If a plan provides for this feature, the Committee Report states that all employees who die or become disabled while on a military leave be credited with service and benefits on a reasonably equivalent basis (i.e., the provision is subject to the Code’s nondiscrimination requirements).
The HEART Act provides that, for an employee who dies or becomes disabled in active military service, the amount of contributions and elective deferrals for this purpose is determined based on the individual’s average actual contributions or elective deferrals for the 12-month period of service with the employer immediately before the qualified military service, or, if less, the actual length of continuous service.
Under PPA and the Committee Report, it is unclear whether an employer may provide for such benefit accruals on a selective year basis (for example, provide for such accruals in one year and discontinue them in the following year). Therefore, employers should carefully take into account the cost and other relevant considerations when deciding whether to add this feature to their plans.
The above provisions apply with respect to deaths and disabilities occurring on or after January 1, 2007.
Health Flexible Spending Arrangements
Health flexible spending accounts (“Health FSAs”) are health plans or arrangements typically associated with cafeteria plans under Section 125 of the Code (“Cafeteria Plans”). Generally stated, a Health FSA is a plan or program which is designed to reimburse employees for certain health and medical expenses that are not covered under other benefit plans or insurance. Employees who participate in a Health FSA make pre-tax contributions from their compensation to a FSA account. Upon incurring medical expenses that are not otherwise covered from other sources, an employee requests reimbursement from the FSA account. One consideration with respect to contributing to a Health FSA account is the “use-itor- lose it” rule, which requires the forfeiture of any unused amounts in a FSA account at the end of the plan year (or, if a plan provides for a grace period of up to two and one half months following the end of the plan year, then until the end of such grace period).
The HEART Act added Section 125(h) to the Code, which provides a special rule allowing (but not requiring) qualified reservists distributions of unused amounts in a Health FSA account. Notably, for this purpose, a “qualified reservist distribution” is defined in the HEART Act, and explained in Internal Revenue Service (“IRS”) Notice 2008-82 (the “Notice”), as a distribution to an employee of all or a portion of the balance in the employee’s Health FSA account if: (i) the employee is a member of a reserve component ordered or called to active duty for a period of more than 180 days or for an indefinite period and (ii) the request for distribution is made during the period beginning with the order or call to active duty and ending on the last day of the plan year (or grace period, if applicable) including the date of the order or call to active duty. These qualified reservist distributions are an exception to the general rule stating that a Health FSA may not make distributions other than reimbursement of substantiated medical expenses.
The Notice clarifies that a Cafeteria Plan is not required to provide for qualified reservist distributions. In addition, the Notice indicates that a qualified reservist distribution may not be made before a Cafeteria Plan is amended to provide for qualified reservist distributions from a Health FSA. A Cafeteria Plan may be amended at any time on a prospective basis and must apply uniformly to all participants in the Cafeteria Plan. However, under a transition rule, the Notice provides a transition that allows a Cafeteria Plan to be amended retroactively to permit for qualified reservist distributions requested on or before December 31, 2009, provided that the amendment is made by December 31, 2009 and is effective retroactively to the date of the first qualified reservist distribution paid under the Cafeteria Plan (but not prior to June 18, 2008). Regardless of when the Cafeteria Plan is amended, the transition rule does not allow an employee to request a qualified reservist distribution with respect to a plan year after the last day of the plan year (or grace period, if applicable) during which the order or call to active duty occurred.
The Notice also provides details as to: (i) when a qualified reservist distribution may be made; (ii) various methods for determining the balance in a Health FSA available as a qualified reservist distribution; (iii) cafeteria plan procedures to be followed with respect to requesting of a qualified reservist distribution; (iv) the effect on the cafeteria plan nondiscrimination rules and (v) the taxation of a qualified reservist distribution. Employers who are considering adding these qualified reservist distributions to their Health FSAs should seek legal advice on, and carefully take into consideration, the details of these provisions.
What Employers Need To Do Now
Employers sponsoring tax-qualified plans, and health and welfare plans containing Health FSAs, should carefully review their obligations with respect to the mandatory HEART Act provisions that are already effective (for plan years beginning on or after January 1, 2009). As previously stated, plans need to be amended by the last day of the first plan year beginning on or after January 1, 2010, to reflect the operation of these mandatory provisions.
Employers also should take time now to consider whether to add any of the optional provisions available under the HEART Act. Some of these provisions, for example, allowing for qualified reservist distributions and/or military survivor benefits, are beneficial to reservists and, therefore, to employers who employ them; however, the cost factor should be taken into account. As a reminder, plans need to be amended to comply with optional provisions by the last day of the plan year in which the plan sponsor elects to provide for such provision(s).
Last, but not least, as always, employers need to communicate any and all plan changes to participants in a timely manner. Adequate and prompt communication goes a long way towards eliminating confusion and possible future disputes.
Qualified reservist distributions and the other pertinent mandatory and optional provisions of the HEART Act require tax-qualified plan and health and welfare plan sponsors to act, and make certain decisions, in the near future. As always, White & Case is available to help you decipher the HEART Act and the Notice, and provide helpful guidance with respect to this matter.
As a practical matter, if a reservist were to, for example, take all of his or her elective deferrals under a 401(k) plan as a qualified reservist distribution, and not repay such amount within the two-year period, this could have an adverse effect on his or her retirement savings. In today’s economy, this is a significant consideration, and employers and reservists should be mindful that qualified reservist distributions should be taken with full knowledge of the practical effects.