New HEART Act Affects Benefit Plans

President Bush on June 17 signed into law the Heroes Earnings Assistance and Relief Tax Act of 2008. The HEART Act will permit or require certain changes to the operation of retirement plans and cafeteria plans for any employer with employees who are also military personnel called to active duty.

Changes for Retirement Plans

Increased Survivor Benefits. Under the HEART Act, qualified retirement plans are required to treat employees who die in active military service as if they had returned to active employment with the employer and then terminated employment as a result of death for purposes of any additional survivor benefits provided under the plan. This change may result in accelerated vesting or other increased survivor benefits from plans that provide special benefits to survivors of an employee whose employment terminates as a result of death. The new requirement does not compel a plan to credit additional benefit accrual service for the period of military service if the employer does not wish to do so.

It is not clear whether plans are required to grant vesting service for the period of military leave if the vesting service is not associated with an increased survivor benefit. This would be relevant in the case of a plan that does not provide immediate vesting for an employee who dies while actively employed. If the employee's military service was of sufficient duration so that vesting service for this period would cause the employee to become vested in a survivor benefit, whether vesting service is required to be granted is an important question. The IRS may need to provide additional guidance on this issue in the future.

This HEART Act requirement is effective retroactively for any military death during active duty that occurred on or after Jan. 1, 2007. Plan amendments must be adopted by the end of the first plan year that begins in 2010.

Increased Benefit Accrual Service. Under current law, an employee who returns to employment from military service in a timely manner is required to be credited with benefit accrual service for the period of military service. Returning to employment is a condition of receiving the extra service credit, and military personnel who became disabled or died during their military service were thus unable to benefit from this rule. Under the HEART Act, plans are permitted to provide benefit accrual service to employees who cannot return to employment as a result of death or disability that occurs while in active military service.

A plan that adds this rule may treat the deceased or disabled employee as if he or she was reemployed on the day prior to death or disability. It may then credit the period of benefit service that would have been earned if the employee had been actively employed during the period of military service up to the death or disability.

For defined benefit plans, service credit would be given under a traditional final average or career-average pay formula. In the case of a cash balance plan formula, retroactive pay credits and interest credits would be granted. For defined contribution plans, employer contributions would be provided for the period of military service up to the date of death or disability. Matching contributions would be given based on the average deferral rate of the employee for the 12-month period prior to military service. Certain nondiscrimination requirements apply.

Plans are permitted to implement these rules for deaths or disabilities that occur on or after Jan. 1, 2007.

Differential Pay. Many employers provide "differential" pay to military personnel, that is, the difference between the amount the individual would have earned if still working for the employer and the amount earned from the military. The status of military differential pay has historically been murky—questions have persisted about issues such as whether differential pay can be treated as pay for 401(k) deferral purposes, whether it can be counted for plan limits, or whether it should be treated as wages for purposes of federal tax withholding.

The HEART Act defines "differential" pay as amounts paid to an employee while on active duty for a period of over 30 days. The Act provides that such pay is wages for purposes of federal income tax withholding. It also provides that such differential pay is treated as compensation for purposes of the Internal Revenue Code, and that an individual receiving differential pay is treated as an employee for purposes of entitlement to make and receive contributions under the plan. (The Act leaves open the question of whether service must be credited for any period during which an employee receives differential pay.) Finally, the Act provides that although an individual receiving differential pay must be treated as an employee for certain purposes, a 401(k), 403(b) or 457(b) plan may still make a distribution of elective deferrals to the individual by treating him or her as having separated from service for this purpose.

These requirements are effective for differential pay paid after 2008.

Changes for Cafeteria Plans

Qualified Reservist Distributions. Employers are permitted to add "qualified reservist distributions" to their cafeteria plans. This would permit an employee called to active duty for a period of at least 179 days, or for an indefinite period, to receive a distribution of the unused balance of his or her health flexible spending account (FSA). The distribution must be made by the deadline for making reimbursements under the health FSA that applies to the year in which the employee was called to active duty.

Although the HEART Act is not clear on this point, presumably this time period includes any grace period (up to 2 ½ months) in the next year, if the plan provides for one. The HEART Act does not address several other issues associated with these qualified reservist distributions, including the taxability of such a distribution. Such matters will likely be the subject of IRS guidance in the future. This provision of the HEART Act is effective for distributions made on or after June 17—although employers should amend their cafeteria plans before making any qualified reservist distributions.

Plan Amendments Required

Compliance with the HEART Act will require plan amendments to many retirement plans by Dec. 31, 2010 (for calendar year plans). In addition, any employer that wants to add qualified reservist distributions to a cafeteria plan must amend the plan and distribute a revised summary plan description or summary of material modification by the appropriate deadlines for the effective date the employer chooses for implementation of the change.

If you have any questions about the HEART Act or any other issues affecting your benefit plans, please contact the lawyer in our firm who is principally responsible for your employee benefits work.