United States: HEART Act Affects Qualified Plans, Health FSAs, And Military Differential Pay

In June, the President signed the Heroes Earnings Assistance and Relief Tax Act ("HEART Act") into law. The HEART Act amends certain provisions that were added by the Uniformed Services Employment and Reemployment Rights Act of 1994 ("USERRA"). The HEART Act requires certain changes for retirement plans and permits other changes, changes the treatment of military differential pay for purposes of retirement plans and income tax withholding, permits certain changes to health FSAs, and adds special withholding provisions for certain expatriate employees.

Mandatory Change For Retirement Plans

The HEART Act amends the Internal Revenue Code ("Code") to require tax-qualified plans (such as 401(k) plans, pension plans, and ESOPs), 403(b) plans, and governmental 457(b) plans to provide to survivors of any participant who dies while performing qualified military service (as defined in USERRA) the same benefits under the plan as if the participant died while employed with the employer, such as accelerated vesting. This rule, however, does not require survivors to be provided any benefit accruals relating to the period of qualified military service.

This change applies for deaths on or after January 1, 2007. Plans (other than governmental plans) must be amended to add this provision by the end of the first plan year beginning on or after January 1, 2010. Governmental plans must be amended by the end of the first plan year beginning on or after January 1, 2012.

Mandatory Changes For Retirement Plans Related To Military Differential Pay

Military differential pay is compensation that an employer pays to its employees called to active duty to make up all or part of the difference between what the employee is earning in the military and what the employee would be earning if he or she was still employed with the employer. Prior to the HEART Act, military differential pay was not subject to withholding for federal income tax, FICA, or FUTA purposes. Under the HEART Act, employers providing military differential pay must withhold on that pay for federal income taxes after 2008 if the employee is performing duty in the uniformed services on active duty for a period of more than 30 days. However, employers are still not required to withhold for FICA and FUTA purposes.

In addition, the HEART Act amends Code Section 414(u) to provide that a participant receiving military differential pay will be treated as an employee of the employer and the military differential pay will be treated as compensation for purposes of the plan. This requirement is applicable to tax-qualified plans, 403(b) plans and 457(b) plans.

However, somewhat inconsistently, the Act also requires that, for purposes of 401(k), 403(b), and 457(b), a participant serving more than 30 days in the uniformed services will be treated as having separated from service so that the participant's benefit may be distributed in whole or in part from the applicable plan. If a participant takes such a distribution, he or she must be prohibited from making contributions to the plan for six months beginning on the date of the distribution.

The changes to Code Section 414(u) apply on or after January 1, 2008. Plan sponsors, whether or not they provide military differential pay, will need to amend their plans to address these changes. Plans must be amended to add these provisions by the end of the first plan year beginning on or after January 1, 2010 (January 1, 2012 for governmental plans).

Permissive Changes To Retirement Plans

The HEART Act amends Code Section 414(u) to permit (but not require) employers to treat any participant who dies or becomes disabled while performing qualified military service as if the participant died or became disabled while employed for benefit accrual purposes. For plans with elective deferrals or after-tax employee contributions, the amount of the contributions for purposes of this rule is determined by the contributions made by the participant in the 12 months before the qualified military service (or the actual period of service with the employer, if less).

Tax-qualified plans, 403(b) plans, and 457(b) plans may add these provisions. These provisions apply to deaths and disabilities that occur on or after January 1, 2007, but plans wishing to provide these benefits may be amended as late as the first plan year beginning on or after January 1, 2010 (January 1, 2012 for governmental plans).

In addition, the HEART Act also amends Code Section 414(u) to permit contributions and benefits under tax-qualified plans, 403(b) plans, or 457(b) plans to be based on military differential pay. If an employer allows contributions or calculates benefits based on military differential pay, the payment of the military differential pay must be available to participants on reasonably equivalent terms. In the case of contributions, the ability to make contributions from the differential pay must also be available on reasonably equivalent terms.

This change to Code Section 414(u) applies to tax-qualified plans, 403(b) plans, or 457(b) plans on or after January 1, 2008. Plan sponsors that want to provide this benefit need to amend their plans to address this change by the end of the first plan year beginning on or after January 1, 2010 (January 1, 2012 for governmental plans).

The HEART Act also eliminates the 10% early (that is, pre-59½) distribution penalty for "qualified reservist distributions" from 401(k) and 403(b) plans after December 31, 2007. Qualified reservist distributions are distributions of amounts attributable to elective deferrals from 401(k) or 403(b) plans to reservists called to active duty for at least 179 days or for an indefinite period of time. The ability of plans to make qualified reservist distributions was added by USERRA. Before amendment by the HEART Act, the waiver of the early distribution penalty only applied through December 31, 2007. While the change to eliminate the 10% early distribution penalty is mandatory, plans are not required to offer qualified reservist distributions.

Permissive Changes To Health FSAs

The HEART Act amends Code Section 125 (related to cafeteria plans) to permit a different kind of "qualified reservist distribution" from health flexible spending accounts ("Health FSAs"). A qualified reservist distribution from a Health FSA is a distribution of the entire remaining balance of the Health FSA of a reservist who is called to active duty for at least 179 days or for an indefinite period of time. A qualified reservist distribution must be made after the reservist is called to active duty and before the last date reimbursements could be made under the Health FSA. Presumably, reservists called to active duty would be able to take qualified reservist distributions during any grace period that may be available under the plan.

The HEART Act does not address the interaction of this optional provision with the continuation coverage requirements of USERRA or COBRA or the uniform coverage rule. Plans may be amended to add this provision any time after the enactment of the HEART Act, but before qualified reservist distributions will be offered under the Health FSA.

Extension Of Mental Health Parity Act

Under the HEART Act, the Mental Health Parity Act has been extended from the date of its enactment (June 17) until the end of 2008. The Mental Health Parity Act requires health plans offering mental health benefits with annual or lifetime limits on those benefits to provide that such limits are no more restrictive than the limits that apply to medical and surgical benefits. This change is not likely to require action on the part of plan sponsors, as many did not amend their plans for the prior December 31, 2007 expiration of the Mental Health Parity Act.

New Withholding Rules For Expatriates

The HEART Act also requires a mandatory 30% withholding on payments of certain deferred compensation items (including tax qualified and nonqualified plans) to an employee after he or she becomes an expatriate. In addition, when an individual becomes an expatriate, certain tax-deferred accounts, including individual retirement accounts or annuities (IRAs) and health savings accounts (HSAs), are treated as having been immediately distributed.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.