02 Jul Tax Issues Surrounding U.S. Military Retirement
When adjusting to civilian life it is important to understand what is taxable and what is not taxable in regard to your pay after service to the US Military. This post is a rudimentary overview to some of those issues that were garnered from perusing the web site www.military.com which offers detailed explanations of all things military. The biggest lesson learned is that unless a retroactive disability benefit has been determined for a veteran who has elected the annuity option, you can usually rely on the 1099-R to efficiently prepare military retiree tax returns.
After retiring from the military veterans may continue to receive payments from either the Defense Finance and Accounting Service (DFAS) or the Veterans Administration (VA). Payments from DFAS are either regular, non-disability military retirement pay or military disability retirement pay.
Non-disability retirement pay is an ordinary pension-type retirement awarded to military service members upon completing service to the military. The amount of pay is based only on years of service, and all of it is considered ordinary income.
Military disability retirement pay is awarded when a service member leaves military service based on a disability. The amount of pension received is calculated based on years of service and a portion of this pay is allocated as disability. Both of these types of military retirement are paid by the DFAS. Another payment type is from the VA, which is based only on VA-rated disability percentages. The payments from the VA are never taxed.
Prior to 2004, a retiree was not permitted to receive both military retirement pay and VA disability benefits unless he forfeited the portion of his DFAS payment that was equal to the VA payment. Because the VA payment was tax free, most veterans elected this option. Since 2004, military retirees with a fifty percent or greater VA-rated disability, and at least twenty years of service, are no longer required to waive DFAS payments in order to receive VA compensation. This new law is being phased in over nine years.
In order to determine what is taxed or not taxed on DFAS payments, you must first determine whether you were a member of the military on September 24, 1975? If so then none of the disability portion of the retirement is taxable. If not, then the disability portion of length-of-service pay is taxed and the retirement pay based solely on disability is also taxed unless all pay is based on disability and the disability is the result of an armed conflict; extra-hazardous service; simulated war; or an instrumentality of war; or the veteran made an election under the Retired Serviceman’s Family Protection Plan (SFPP) or the Survivor Benefit Plan (SBP) per Reg. Sec. 1.122-1(c)(1). If this election has been made, the bottom of your account statement, under the heading “Survivor Benefit Plan (SBP) Coverage,” will indicate this election or will state, “No SBP Election is reflected on your account.”
However I have recently realized that the IRC Sec. 1.122-1 – Net Disability Exclusion, is actively being cited and used incorrectly by many tax practitioners. The www.Veteranstaxpackage.com website states: If you have a disability rating that has been confirmed by letter from the Veterans Administration and/or receive retired military pay from any branch in the military and pay taxes each year due to a high tax liability, you more than likely qualify. In reading the governing statute it is relatively easy to incorrectly assume that most partly disabled persons qualify for the net disability exclusion. Please be advised, this code section applies specifically to those veterans who, after December 31, 1965, have made an election under the Retired Serviceman’s Family Protection Plan (10 U.S.C. 1431) or the Survivor Benefit Plan (U.S.C. 1447). Taxpayers fitting in this criteria may exclude from gross income under Sec. 122(b) all amounts received as uniformed services retired or retainer pay until there has been so excluded an amount of retired or retainer pay equal to the ‘consideration of the contract.’ (Sec. 1.122-1 (2)(i)).
On a related note any veteran who elected to have part of his or her retirement pay held back to be placed into an annuity for the benefit of either his or her family (SFPP) or spouse (SBP) can reduce his or her gross income by the amount of the retirement held back. A review of code section 1.122-1(c)(1) and accompanying examples should help explain how the calculations are made. Here you will see this exclusion is a one-time adjustment and is relevant for retirees prior to January 1, 1966 who elected the annuity for their family or spouse and paid taxes on the annuity premium.
Form 1099 shows the military retiree’s net retired pay received from the Department of Defense, that is, after VA disability compensation is deducted making whatever is reported on the 1099 taxable retirement pay. The only exception to this I could find occurs when the VA retroactively awards a disability rating or increases a rating.