President Bush signed the Heroes Earnings Assistance and Relief Tax Act (H.R. 6081) into law on June 17, 2008. The Heroes Act (also called the HEART Act) provides individuals performing qualified military service with certain additional rights to benefits under employer-sponsored pension and welfare plans as well as a number of tax benefits.

Some of the changes required by the Heroes Act have retroactive effective dates that may have an immediate impact on the benefits payable to or on behalf of employees who are performing qualified military service.

New Retirement Plan Rights

The Heroes Act grants a number of new benefit rights under employer-sponsored retirement plans to employees on military leave, including the following:

  • Death Benefits for Plan Participants on Military Leave

The Heroes Act modifies USERRA (Uniformed Services Employment and Reemployment Rights Act) to require 401(a) qualified retirement plans, 403(b) annuity arrangements and governmental 457(b) plans to treat plan participants who die while performing qualified military service as having resumed active employment immediately prior to their death, except that the plan need not credit benefit accrual service for the participant’s period of qualified military service. This provision has the effect of requiring retirement plans to provide former employees who die while on qualified military leave with the same death benefits provided to participants who die while actively employed.

Effective for all deaths after January 1, 2007.

  • Treatment of Differential Pay as Wages The Heroes Act changes the treatment of “differential pay” in several ways. “Differential pay” is compensation voluntarily paid by employers to employees who are called up for active military duty to supplement their military pay. The new requirements apply if the employer provides differential pay to employees who are on qualified military service for more than 30 days:
    • The differential pay must be treated as wages subject to income tax withholding.
    • Any person receiving differential pay must be treated as actively employed by the employer making the payment and the differential pay must be taken into account as compensation for contribution and benefit accrual purposes under the employer’s retirement plans (including 401(a) qualified retirement plans, 403(b) annuity arrangements and 457(b) plans). 
    • Contributions and benefits attributable to differential pay will not cause the employer’s retirement plan to fail the applicable nondiscrimination requirements if (i) all employees within the employer’s controlled group are entitled to receive differential pay on reasonably equivalent terms and (ii) all employees receiving differential pay who are eligible to participate in any retirement plan maintained within the employer’s controlled group are eligible to make contributions with respect to differential pay on reasonably equivalent terms.
    • Any person receiving differential pay must be treated as having severed his or her employment with the employer throughout the entire period of qualified military service solely for purposes of determining his or her right to receive a distribution from the employer’s 401(k) plan, 403(b) annuity or 457(b) plan. Any person electing to receive a distribution under this provision is prohibited from making elective deferrals under the plan for a period of six months. 
    • Differential pay must be included in compensation for purposes of determining the limitations on contributions to IRAs.

Effective for plan years beginning after December 31, 2008

  • Timing of Plan Amendments

Plan documents must be amended to reflect these requirements on or before the last day of the first plan year beginning on or after January 1, 2010.

Optional Benefit Enhancements

The Heroes Act also permits (but does not require) employers to make certain changes to their benefit plans to enhance the benefits of employees on military leave.

  • Benefit Service Credit for Employees Who Die or Become Disabled While on Military Leave

The Heroes Act permits an employer to provide contributions or benefit accruals to an employee who dies or becomes disabled while performing qualified military service as long as it provides contributions and benefit accruals on reasonably equivalent terms to all employees who die while performing qualified military service. Prior to the Heroes Act, USERRA provided that contributions and benefit accruals could only be made for those employees who resumed employment with reemployment rights following qualified military service.

Effective for death or disability occurring after January 1, 2007. If a plan is operated in accordance with this provision, the plan amendment must be adopted no later than the last day of the first plan year beginning after January 1, 2010.

  • Distributions of Unused Health Benefits in Flexible Spending Arrangements

Under the “use it or lose it rules” applicable to health flexible spending accounts, any balance remaining in an employee’s flexible spending account at the end of the plan year that is not used to reimburse the employee for qualifying medical expenses must be forfeited. The Heroes Act allows an employer to amend its flexible spending account arrangements to allow employees who are ordered or called to active duty for a period of 180 days or more (or for an indefinite period) to receive a distribution of “all or a portion of the balance” in their flexible spending account if payment is made between the day the employee is called to active service and the last day health care expense reimbursements could be made under the terms of the flexible spending arrangement.

Effective for distributions made after June 17, 2008.

Additional Tax Benefits

The Heroes Act also provides the following benefit-related tax breaks to individuals performing qualified military service and to the employers of such individuals:

  • Extension of Waiver of Early Withdrawal Tax Penalty for Qualified Reservist Distributions

Plan participants who receive distributions from a 401(a) qualified retirement plan, a 403(b) annuity or an individual retirement account prior to age 59½ are generally subject to a 10% early withdrawal tax in addition to income tax. The Pension Protection Act of 2006 created an exception to the early withdrawal tax penalty for individuals who are ordered or called to active duty for a period of 180 days or more (or for an indefinite period). This “Qualified Reservist Distribution” exception expired for individuals called to active duty after December 31, 2007. The Heroes Act made Qualified Reservist Distribution exception permanent.

  • Employer Tax Credit for Differential Pay to Military Reservists

The Heroes Act provides a tax credit to small business employers equal to 20% of the differential wage payments the employer makes to qualified employees. To qualify for the tax credit, the employer must employ an average of less than 50 employees on business days during the year and must provide differential wage payments to all eligible employees. Eligible employees are those employees who were employed by the employer within the 91-day period preceding the period during which the differential wage payments are made and who are called to active duty for a period of more than 30 days. Small business employers who take advantage of this tax credit may not receive a credit for any portion of differential wages paid to an employee in excess of $20,000 for the taxable year and may not take a deduction under Code Section 162(a)(1) for the differential wages paid to the employee.

Effective for differential wages paid after June 17, 2008 and before January 1, 2010

Employers will need to reexamine their military leave pay practices and retirement plans to ensure compliance with the new requirements, some of which became effective immediately or even retroactively. Employers may also wish to take advantage of some of the optional benefit enhancements to assist employees who are called up to active military duty.