Military families have a new way to make the best of a tragic situation. A recent amendment to tax law allows survivors of fallen servicemembers to roll their military death gratuities and/or life insurance proceeds into certain tax-advantaged accounts for retirement or education. For those grieving a loss, the law opens a new realm of possibilities for their future financial security. But survivors should step carefully when deciding whether to take advantage - a rollover isn't always the right move.
When a servicemember dies, the surviving family often receives substantial benefit proceeds from the government. The payout consists of the default $400,000 from Servicemembers' Group Life Insurance (automatic unless the servicemember opted for less coverage), plus a "death gratuity" of $100,000 for those who died while on active duty. While the money can help replace the loss of income, managing the sudden influx of cash can also present an overwhelming challenge for families in the midst of suffering.
The new law, part of the Heroes Earning Assistance and Tax Relief (HEART) Act of 2008, gives survivors an easy way to put the money to good use immediately in a Roth IRA or Coverdell Education Savings Account (CESA). Under normal circumstances, these accounts have annual contribution limits, but military beneficiaries can now bypass those rules by rolling some or all of their proceeds to either or both accounts.
In addition to providing families a simple solution for investing the money, the rollover move offers tax advantages that are potentially enormous. Unlike other investments, money in a Roth IRA or a CESA grows and compounds in a tax-deferred account and is generally not taxable upon withdrawal. So when the money is needed for retirement or education expenses, there's likely to be much more of it than if it had been invested in a taxable account.
Not Right for Everyone
For some recipients, the new rollover rule provides an opportunity to attain their retirement or college savings goals with one massive contribution. Many families, however, should think twice before devoting their entire benefit payment to a Roth IRA or CESA. Because, simply put, once the money is in, you can't change your mind.
Each account has specific rules about when and how the money can be used. For example, withdrawing any Roth IRA earnings before age 59 - could result in a 10 percent penalty on top of ordinary income taxes. And a CESA can only be tapped for qualified education expenses such as tuition and books.
These limitations are significant for survivors who may need the extra money for different purposes. Most servicemembers engaged in combat are men under age 40, and many have young children. Their families, who counted on their income for support, are likely to need immediate help covering daily expenses, such as groceries and mortgage payments. If too much money is tied up in inaccessible accounts, they may be stuck in a tough position.
Thankfully, the new law under the HEART Act isn't an all-or-nothing proposition. Families who receive the death-related benefits have the choice to roll over a portion of their funds to a Roth IRA or CESA, and reserve the rest for lifestyle or unforeseen expenses. Allocating the money to several different places might make the transaction a little more complicated, but it could also help to ensure the family will be protected in every scenario.
Whether investing for long-term goals, drawing money for everyday needs, or a combination of both, it's important for anyone with a sudden windfall to have a plan of action. Managed irresponsibly, even $500,000 can disappear into thin air with little to show for it. A financial planner can help determine the top priorities and recommend strategies that apply to the family's overall financial picture. Even before saving and investing, for example, it may be wise to pay off outstanding debts and establish appropriate levels of insurance.
It goes without saying that no amount of money can replace a lost loved one. But the government's latest move, paired with smart financial decisions, can make it easier to honor their memory with a life well-lived.
June Walbert is a CERTIFIED FINANCIAL PLANNERTM practitioner with USAA Financial Planning Services, one of the USAA family of companies. Walbert is a lieutenant colonel in the U.S. Army Reserve.