A tax break for the military

The new Heroes Earnings Assistance and Relief Tax Act of 2008 contains several retirement plan provisions for military service personnel that financial advisers must know about.

The act made permanent an exception to the 10% early-distribution penalty for withdrawals by active reservists from their retirement plans (individual retirement accounts and employer plans). The exception was part of the Pension Protection Act of 2006 and expired Dec. 31.

The 10% penalty exception applies to reservists called to active duty for 180 days or more who take a distribution from a retirement plan during that time. It is effective for distributions taken after Aug. 16, 2006.

In addition, the amount of the distribution can be repaid to the retirement plan within two years of the end of reservists’ active-duty periods. The repayment option was also retroactive for withdrawals taken from Sept. 11, 2001, through Aug. 17, 2006.

Those repayments must be made by Aug. 17.

Here is an example: Doug, 32, was called to active duty May 1, 2003.

He took a distribution of $25,000 from his 401(k) while on active duty, which ended July 15, 2004. Doug has until Aug. 17 to repay the $25,000 he withdrew from his plan.

The individual isn’t eligible to take a deduction for the amount repaid to the plan. In order to avoid having after-tax (non-deductible) amounts in either a plan or an IRA, the repayment should go into a Roth IRA.

The repayment isn’t subject to the annual contribution limits or to the income limits for making a Roth contribution. Another benefit to putting the funds in a Roth IRA is that all growth on the funds will be income-tax-free and the account owner has no required distributions from the Roth IRA.

Another provision of the HEART Act allows a beneficiary of military death gratuities and service members group life insurance to contribute those funds to a Roth IRA or a Coverdell education savings account. Unlike the 10% penalty exception provision, this provision applies to beneficiaries of all military personnel, not just those serving in combat zones.

The contribution can be made without regard to the annual contribution or income limits that apply to those accounts. The contribution must be done within one year of the receipt of the death benefit.

Here is an example: Denise receives an SMGLI beneficiary distribution of $30,000, and her adjusted gross income for the year will be $200,000. Even though her income exceeds the amount to qualify for her own Roth IRA contribution, she can still contribute the full $30,000 death benefit to her Roth IRA as long as she does it within a year of her receipt of the benefit.

This provision is retroactive for deaths from injuries on or after Oct. 7, 2001, and before June 17, 2008. Rollovers for those payments can be done up to June 16, 2009 (one year after the effective date of the law).

The death benefit funds go into a Roth IRA on a qualified-rollover basis and can be pulled out at any time with no tax or penalty. The earnings on those funds, however, can’t.

An early distribution of the earnings will be subject to income tax and the 10% early distribution penalty if under age 591/2.

A partial contribution of the benefits also can be done. Some of the funds can go to a Roth, some to the education savings account, and some can be held out for immediate needs.

The total amount contributed to a Roth and an ESA can’t exceed the total amount of the benefits received.

Funds are considered contributed to the ESA first and the Roth IRA second. Any excess amounts contributed would have to be withdrawn from the Roth IRA first.

Other provisions of the HEART Act affect only company plans and apply to deaths that occur after 2006. Plan participants who die while on active duty must now be treated by the plan as if they returned to work one day before their death.

This would make the deceased plan participant’s beneficiaries eligible for any additional employer benefits that may be available to workers who die while they are active employees.

Up to $20,000 of differential payments made by employers to military personnel in combat zones will now be treated as wages for purposes of making IRA contributions. These funds may also be available for in-service withdrawals.

This provision applies for tax years beginning after Dec. 31.

Ed Slott, a certified public accountant in Rockville Centre, N.Y., created The IRA Leadership Program and Ed Slott’s Elite IRA Advisor Group to help financial advisers and insurance companies become recognized leaders in the IRA marketplace. He can be reached at irahelp.com.

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