If you have clients who serve our country, you should be aware that President Bush signed the Heroes Earnings Assistance and Relief Tax (HEART) Act of 2008 into law on June 17. The new law contains several provisions for military service personnel that affect retirement plans. The Internal Revenue Service (IRS) has not yet issued any regulations on most of the HEART Act's provisions, but advisors need to know that each provision has its own qualifications, effective dates and retroactive dates.

Permanent Exception

Under the Pension Protection Act (PPA) of 2006, active reservists taking premature withdrawals from their retirement plans (IRAs and employer plans) were exempt from the 10% early distribution penalty. This exception was set to expire on Dec. 31, 2007, but a HEART provision makes it permanent. The 10% penalty exception applies to any reservist called to active duty for 180 days or more who takes a distribution from a retirement plan during that time. It is effective for distributions taken after Aug. 16, 2006.

In addition, the reservist can repay the amount of the distribution to the retirement plan within two years of the end of his or her active duty period. The repayment option is also retroactive for withdrawals taken from Sept. 11, 2001, through Aug. 17, 2006. Those repayments must be made by Aug. 17, 2008 (two years after the enactment of the PPA).

For example, assume 32-year-old Doug was called to active duty on May 1, 2003. He took a distribution of $18,000 from his 401(k) while he was on active duty. His active duty ended on July 15, 2004. Doug has until August 17, 2008, to repay the $18,000 he withdrew from his plan.

When the funds are withdrawn from an IRA or employer plan under this exception, they are still subject to income tax. However, when they are repaid, the individual is not eligible to take a deduction for the amount repaid to the plan. To avoid having after-tax (nondeductible) amounts in either an employer plan or an IRA, the repayment should go into a Roth IRA. The repayment is not subject to the annual contribution limits or to the income limits for making a Roth contribution. Other benefits to putting the funds in a Roth IRA are that all future growth will be income tax-free, and the account owner does not have to make any required distributions.

For example, assume Ivor is 25 and is called to active duty on July 12, 2008. He takes $20,000 out of his 401(k) plan on Aug. 1, 2008. Ivor will have to include the $20,000 in his income for 2008, but he will not have to pay the 10% early distribution penalty. His active duty will end on April 1, 2009. Ivor will have until March 31, 2011, to repay the $20,000. He should put the $20,000 into a Roth IRA, since he will get no deduction for repaying the amount.

Tracking IRA Repayments

When a reservist makes a repayment to an employer plan, the employer must track the after-tax amount for the employee. When the repayment is made to an IRA, the account owner must track the after-tax (nondeductible) amount on IRS Form 8606, which is filed with the owner's tax return. The IRA custodian is not responsible for tracking the after-tax amount. The owner files Form 8606 in any year he or she makes an after-tax repayment and in any year he or she takes a distribution from any IRA.

Once the after-tax amount is in the IRA, the owner cannot withdraw only the after-tax amount. All distributions from any of the owner's IRAs, including SEPs and SIMPLEs, will be pro-rated between the pre-tax and after-tax amounts in the owner's IRAs.

For example, assume Mary Ann took a distribution of $8,000 from her IRA while she was on active duty. She repaid the $8,000 to the same IRA in 2008, which is within two years of the termination of her active duty. Mary Ann will not get a deduction for the repayment of the $8,000, so she now has $8,000 in after-tax funds in her IRA. She will have to file Form 8606 with her 2008 tax return to show that the contribution is after-tax funds. If all of Mary Ann's IRAs total $80,000 and she takes a distribution of $5,000, then 10% of her distribution, or $500, will be income tax-free ($8,000/$80,000 = 10% and $5,000 x 10% = $500), and $4,500 of Mary Ann's distribution will be subject to income tax.

If Mary Ann made her $8,000 repayment to a Roth IRA, she wouldn't have to do any Form 8606 tracking and reporting. Instead, she would be able to withdraw her $8,000 at any time, tax- and penalty-free. This would not be true of any other earnings Mary Ann had in the account, however. She must have owned a Roth IRA for at least five years and be over the age of 591/2, dead, disabled or using the money for a first-time home purchase in order to withdraw the earnings, tax- and penalty-free. A beneficiary can do this as well.

Military Death Benefits