Income Tax Gude for Military Veterans and Retirees
This updated report covers currently available income tax information pertinent to military retirees: military retired/retainer pay, military disability retired pay, Department of Veterans Affairs (VA) disability compensation, and information on military retired pay state income tax withholding. Also included are charts of state income tax information on military retired pay and survivor annuities, detailed coverage of the impact of the federal estate tax laws on SBP, and useful state tax web sites and telephone numbers.
Military Disability Retired Pay
A person who is retired for military disability (as distinguished from non-disability retirement based on length of service) and has military pay based on percentage of disability must meet the following conditions for federal income tax exemption: (a) On or before Sep. 24, 1975, the member was entitled to receive retired pay computed on the basis of percentage of disability; or, (b) On Sep. 24, 1975, he or she was a member of the armed forces (or reserve component thereof) or under a binding written commitment to become such a member; or, (c) The member receives disability retired pay because of a combat-related injury. The term combat-related injury means personal injury or sickness incurred as a direct result of armed conflict, or while engaged in extra hazardous service, or under conditions simulating war or an instrumentality of war (26 U.S. Code, Section 104).
For people covered under a, b, or c above, the tax exemption rules are further clarified as follows: (1) If military retired pay is based on the percentage or degree of disability or is paid under disability retirement laws in effect before Oct. 1, 1949, the entire amount is exempt from income tax; (2) Where gross military retired pay is based on years of service (2.5 percent for each year), the amount payable solely on percentage of disability is tax-exempt. The excess, as reported on Form 1099-R, is taxable income.
For people not covered by the previously specified eligibility criteria - that is, primarily persons who became members of the armed forces after Sep. 24, 1975, and who do not receive disability retired pay because of a combat-related injury or who are not eligible for disability compensation administered by the Department of Veterans Affairs - amounts received as disability retired pay are fully subject to taxation.
The basics of federal taxation of military disability retired pay are depicted in the side-bar Federal Tax - Military Disability Retired pay on this page.
Federal Tax--Military Disability Retired Pay
Disability portion --length-of-service pay:
- Member on 24 Sept. 75 NO TAX
- Not member on 24 Sept. 75 TAXED
Retired pay based solely on disability:
- Member on 24 Sept. 75 NO TAX
- Not member on 24 Sept. 75 TAXED, unless
*All pay based on disability, and
*Disability result of armed conflict, extra-hazardous service, simulated war, or an instrumentality of war
VA Disability Compensation
Disability compensation paid by the VA to people with service-connected disabilities is exempt from income tax. To receive VA compensation, a military retiree must waive payment of an equal amount of military retired pay. This VA compensation includes the additional amount payable on behalf of dependents for veterans with a disability rating of 30 percent or higher. Accordingly, the receipt of VA compensation reduces taxable retired pay but only by the amount of the VA award. The percentage or degree of disability assigned by the VA does not exempt the same percentage of military retired pay from income tax, as is the case with a military disability rating.
For military disability retirees who elect to receive VA compensation, the waiver of military retired pay is applied first to the nontaxable portion of retired pay since a dual tax benefit is not allowed for the same disability. Accordingly, there is no tax benefit to a disability retiree from a VA disability award unless the amount of VA compensation exceeds the nontaxable portion of military disability retired pay.
Normally, a few months elapse between the effective date of a VA disability rating and the date the waiver of retired pay is processed by the Defense Finance and Accounting Service Center or respective pay center reducing taxable military retired pay. To receive the tax benefit for the interim period in this situation, the retiree should reduce taxable military retired pay (as reported on Form 1099-R) by the dollar amount of VA compensation that would have been payable had military retired pay been properly reduced during such a period. A brief explanation of the adjustment with a copy of the VA disability award certification should be attached to Form 1040, citing 38 U.S. Code, Section 5301 and IRS Ruling 78-161 as the authority. This procedure also can be followed for retroactive receipt of a VA disability rating; however, since a statute of limitations for such tax relief is not addressed in either reference, the three-year statute of limitations embodied in 26 U.S. Code, Section 6511(d) applies.
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