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When the funds are withdrawn from an IRA or employer plan under this exception, they are still subject to income tax.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

One of the new provisions in the HEART Act allows a beneficiary who receives military death gratuities and Service Members Group Life Insurance (SGLI) to contribute those funds to a Roth IRA or a Coverdell Education Savings Account (ESA). Unlike the 10% penalty exception rule, this provision applies to beneficiaries of all military personnel, not just active reservists. Military beneficiaries can make a Roth contribution without worrying about annual contribution or income limits that apply to those accounts. The contribution must be completed within one year of receiving the death benefit.

For example, assume Jane has an adjusted gross income (AGI) this year of $200,000 and receives an SGLI beneficiary distribution of $30,000. She will be able to contribute up to $30,000 to a Roth IRA within a year of receiving the benefit, even though $30,000 is more than the allowable annual contribution amount and her income would normally make her ineligible for a Roth contribution.

If Jane met the qualifications for making a Roth contribution, she could contribute up to $5,000 ($6,000 if she is age 50 or older) to her Roth IRA in 2008, in addition to the $30,000 SGLI benefit. A beneficiary can contribute the SGLI benefit regardless of other Roth contributions, the Roth contribution limits or the Roth income limits.

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

The beneficiaries of these payouts are often young parents with children who likely will need the funds for immediate expenses. As mentioned, a Roth owner cannot take a qualified distribution of funds (one that is tax- and penalty-free) until he or she has held the account for five years and is 591/2, dies, becomes disabled or uses up to $10,000 of the funds for a first-time home purchase. A beneficiary can do this as well. However, this does not mean that the funds are locked in the Roth until age 591/2 (or one of the other exceptions applies). The funds go into the Roth as a qualified rollover (basis) and can be withdrawn at any time with no tax or penalty. The earnings on those funds, however, cannot. An early distribution of the earnings will be subject to income tax and the 10% early distribution penalty (if under the age of 591/2).

A partial contribution of the benefits is possible. Some of the funds can go to a Roth, some to an ESA and some can be held out for immediate needs. The total amount contributed to a Roth and an ESA cannot 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 first.

For example, assume Mike receives an SGLI beneficiary distribution of $250,000. He immediately contributes $50,000 to an ESA account for his son. The most Mike could now contribute to a Roth IRA is the remaining balance of $200,000 ($250,000 - $50,000). If a beneficiary receives more than one benefit, he or she has one year from the date of receipt of each benefit to make a contribution to a Roth IRA or an ESA.

Other Provisions

Other provisions of the HEART Act affect only company plans. If a plan participant dies while on active duty, the plan must now treat the participant as if he or she had returned to work one day before dying. This would make the deceased plan participant's beneficiaries eligible for any additional employer benefits that may be available to employees who die while they are active employees. The provision applies to employer plans such as 401(k)s, 403(b)s and 457s, and applies to deaths that have occurred after 2006.

In addition, differential payments made by employers to military personnel (members of the National Guard or reserves on active duty for more than 30 days) will be treated as wages for purposes of making IRA contributions. This provision applies for tax years beginning after Dec. 31, 2008.

If your clients are military personnel, you already know they have unique financial planning challenges. If you explain to them how the HEART Act provisions will affect their retirement plans, you will establish yourself as an invaluable resource and guide.

Ed Slott, a CPA in Rockville Centre, N.Y., is a nationally recognized IRA distribution expert and author of several IRA books, including Your Complete Retirement Planning Road Map. For more, visit www.irahelp.com.