In an information release (IR 2006-129), the IRS reminds members of the military serving in Iraq, Afghanistan and other combat zones that under the Heroes Earned Retirement Opportunities (HERO) Act ( P.L. 109-227) they can now put money into an IRA, even if they only received tax-free combat pay. In addition, military personnel who received tax-free combat pay in either 2004 or 2005 can make IRA contributions for those years until May 28, 2009.

Observation: The Pension Protection Act of 2006 (P.L. 109-280) provides additional IRA relief for called-up reservists by exempting from the Code Sec. 72(t) 10% early withdrawal penalty tax a distribution from an IRA (or attributable to elective deferrals under a Code Sec. 401(k) plan, Code Sec. 403(b) annuity, or certain similar arrangements) that's (1) made to reservists ordered or called to active duty after Sept. 11, 2001, and before Dec. 31, 2007, for a period of more than 179 days or for an indefinite period, and (2) made during the period beginning on the date of the order or call to duty and ending at the close of the active duty period. (Code Sec. 72(t)(2)(G), as amended by Act § 827)

Background on IRA contributions. For tax years beginning after 2003, the HERO Act provides that for purposes of the IRA contribution limits of Code Sec. 219(b)(1)(B) and Code Sec. 219(c), the amount of compensation includible in an individual's gross income is determined without regard to the exclusion from income for combat pay under Code Sec. 112. (Code Sec. 219(f)(7), as amended by HERO Act § 2, see Federal Taxes Weekly Alert 05/25/2006 and 06/01/2006)

In general, an individual who isn't an active participant in certain employer-sponsored retirement plans, and whose spouse isn't an active participant, may make an annual deductible cash contribution to an IRA up to the lesser of: (1) a statutory dollar limit (for 2006, $4,000, increased to $5,000 for those age 50 or older) (Code Sec. 219(b)(1)(A)), or (2) 100% of the compensation that's includible in his gross income for that year. (Code Sec. 219(b)(1)(B)) If the individual (or his spouse) is an active plan participant, the deduction phases out over a specified dollar range of adjusted gross income (AGI).

An individual who files a joint return and has less taxable compensation than his spouse may contribute to a spousal IRA and for 2006 deduct the lesser of $4,000 (or $5,000 if age 50 or older), or (2) the sum of (a) that individual's includible compensation for the tax year, plus (b) the includible compensation of the individual's spouse reduced by the sum of the spouse's allowable IRA deduction, designated nondeductible IRA contribution, and Roth IRA contribution for that tax year. (Code Sec. 219(c))

Background on combat pay exclusion. Under Code Sec. 112, combat-zone compensation is excluded from income (for commissioned officers, the exclusion is limited to the maximum enlisted amount). Areas designated as combat zones include Afghanistan (combat zone benefits also are available for countries such as Pakistan directly supporting military operations), and the Arabian Peninsula Areas (includes Persian Gulf, Red Sea, Gulfs of Oman and Aden, and total land areas of Iraq, Kuwait, Saudi Arabia, Oman, Bahrain, Qatar, and the United Arab Emirates).

IRS highlights new law change. In IR 2006-129, IRS reminds taxpayers that they can now count tax-free combat pay when determining whether they qualify to contribute to either a Roth or traditional IRA. Before the HERO Act's change, members of the military whose earnings came entirely from tax-free combat pay were generally barred from using IRAs to save for retirement. (IR 2006-129)

IRA contribution for 2004 and 2005. Military personnel who received tax-free combat pay in either 2004 or 2005 can go back and make IRA contributions for those years. For those under the age of 50, the IRA contribution limit was $3,000 for 2004 and $4,000 for 2005. For those 50 and over, the limit was $3,500 for 2004 and $4,500 for 2005. These military members have extra time, until May 28, 2009, to make these special back-year contributions. (IR 2006-129)

Observation: Specifically, Act § 2(c)(1) of the HERO Act provides that individuals who received combat pay excluded under Code Sec. 112 for any tax year beginning after Dec. 31, 2003, and ending before the May 29, 2006, have a three-year period in which to make a contribution to an IRA for that tax year, and have the contribution treated as having been made on the last day of that tax year. Since most individuals report on the calendar year, this generally means that individuals who received excluded combat pay in 2004 or 2005 have 3 years after May 29, 2006 to make an IRA contribution for either or both of those years. Thus, individuals have until May 28, 2009 to make an IRA contribution for either or both of these years.

Observation: Taxpayers may also qualify for the Code Sec. 25B “saver's credit” for their contribution to an IRA. For tax years beginning before 2007, an eligible lower-income taxpayer can claim a nonrefundable tax credit for the applicable percentage of up to $2,000 of his qualified retirement savings contributions. The applicable percentage (50%, 20%, or 10%) depends on filing status and AGI.

While contributions to a traditional IRA are often, though not always, deductible, whether deductible or not, they must be reported for the year made. Deductible contributions are reported on Form 1040, 1040A or 1040NR. Nondeductible contributions are reported on Form 8606 (usually attached to the individual's return). If a return has already been filed for a particular year, contributions should be reported on an amended return, Form 1040X. (IR 2006-129)

Roth IRA. IRS also noted that taxpayers choosing to put money into a Roth IRA don't need to report these contributions on their individual tax return. Roth IRA contributions are not deductible, but distributions, usually after retirement, are normally tax-free. Income limits and other special rules apply.

Observation: Thus, IR 2006-129 confirms that the HERO Act provision also applies for purposes of making contributions to a Roth IRA. Although the HERO Act doesn't amend Code Sec. 408A, which deals with Roth IRAs, the Roth contribution limit is tied to the deductible limits under Code Sec. 219 (determined without regard to the phaseout rules), which was amended by the Act.

Recommendation: Since combat zone compensation is excluded from the gross income of a member of the military, any IRA deduction that he takes can offset income from other sources. However, if he has no significant amount of taxable income from other sources, he should instead consider making a contribution to a Roth IRA for the year because the eventual distribution from the Roth IRA will be tax-free if certain requirements are met.