Tax Treatment of U.S. Military Retirement and Disability Benefits
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CHAPTER 12
U.S. MILITARY RETIREMENT AND DISABILITY BENEFITS
Synopsis
§12.00 Introduction
§12.01 Overview of Taxation of Military Benefits
[1] Taxation of Retired Pay and Survivor Benefits
[2] Taxation of Disability Pay
[3] Distributions from the Thrift Savings Plan
§12.02 Military Retired Pay and Survivor Benefits
[1] Taxation of Retired Pay and Survivor Benefits
[2] Treatment of Coverage Outlays
[3] Income Tax Withholding from Military Retired Pay
§12.03 Military Disability Benefits
[1] Calculation of Military Disability Benefits
[2] Taxability of Disability Pay Received from a Branch of the U.S. Military
[3] Disability Payments from the Department of Veterans Affairs
[4] Refund of Costs of Survivor Benefit Coverage Due to VA Disability Offset
[5] Coverage Outlays Not Recoverable Against Nontaxable Disability Benefits
[6] Reduced Military Retired Pay During Civilian Government Employment
§12.04 The Thrift Savings Plan (TSP)
§12.05 Estate or Gift Tax Imposed on Survivor Benefits
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§ 12.00 Introduction
This chapter discusses the taxation of U.S. military retired pay, disability pay, and survivor benefits. The taxation of these benefits may differ depending on whether a retiree receives all or part of them for disability. The taxation of beneficiary survivor benefits may also differ depending on whether the retiree contributed to their cost. However, disability benefits paid to a retiree or beneficiary by the Department of Veterans Affairs (VA) are generally nontaxable.
As used in this chapter, the term ''U.S. military'' includes the Army, Navy, Air Force, Marine Corps, and Coast Guard (and their National Guard and Reserve components).1
FOOTNOTE:
1. 37 USC § 101(4), (24).
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§ 12.01 Overview of Taxation of Military Benefits
[1] Taxation of Retired Pay and Survivor Benefits
U.S. military retired pay and survivor benefits are generally taxable. However, a retiree does not pay tax on certain amounts received for disability. Nor does the retiree pay tax on the portion of retired pay used to cover the cost of benefits for surviving beneficiaries. The military branch must withhold income tax on the taxable portion of retired pay at rates applicable to wages. (See § 12.02 for a more complete discussion.)
[2] Taxation of Disability Pay
Disability retired pay received from a branch of the U.S. military is generally nontaxable if it is for combat-related injuries or sickness resulting from active service. However, all disability payments received from the Department of Veterans Affairs (VA) are nontaxable (whether or not the retiree's injury or sickness is combat-related). In addition, retired pay received from a military branch is nontaxable to the extent the retiree could have applied for and received the benefits instead from the VA. (See § 12.03 for a more complete discussion.)
[3] Distributions from the Thrift Savings Plan
The rules applicable to distributions from qualified retirement plans apply to the Thrift Savings Plan. (See § 12.04 for a more complete discussion.)
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§ 12.02 Military Retired Pay and Survivor Benefits
[1] Taxation of Retired Pay and Survivor Benefits
If a retiree is not disabled, the retiree's U.S. military retired pay and beneficiaries' survivor benefits are generally taxable.1 However, the retiree does not pay tax on amounts withheld to pay the cost of benefits for surviving beneficiaries.2 If due to divorce, the retiree's former spouse owns an interest in the retiree's retired pay, payments to the spouse are taxable to him or her.3
[2] Treatment of Coverage Outlays
A retiree does not pay tax on retirement pay treated as a recovery of the retiree's previous deposits to pay for survivor benefits. These recoverable deposits consist of (1) direct deposits with a military branch, and (2) pre-1966 reductions in the retiree's retired pay (less any portion recovered tax-free by beneficiaries before 1966).4 For convenience, this book refers to these deposits as ''coverage outlays.''
Retired pay is nontaxable until the retiree has recovered the total amount of his or her coverage outlays.5 If the retiree is unable to recover the outlays during his or her lifetime, survivor benefits received by beneficiaries are nontaxable until they have recovered the remainder of the outlays.6
[3] Income Tax Withholding from Military Retired Pay
A military branch must withhold income tax on the taxable portion of retired pay at rates applicable to wages.7
FOOTNOTES:
1. IRC § 61.
2. IRC § 122(a).
3. Pfister v. Comm’r, 359 F3d 352 (4th Cir 2004).
4. IRC § 122(b)(2); Treas Reg § 1.122-1(b)(2)(iii)(a), (b), (d). Although coverage outlays may in some cases also include a $5,000 death benefit exclusion available for persons dying before August 21, 1996, this death benefit exclusion was not available for deceased military retirees. Treas Reg § 1.122-1(b)(2)(iii)(c); IRC § 101(b)(2)(D) (1995); Pub L No 104-188, § 1402(a).
5. IRC §§ 72(n), 122(b).
6. Treas Reg § 1.122-1(b)(2)(ii).
7. Temp Treas Reg § 35.3405-1T, Q&A A-18, A-21; IRS Publication 505.
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§ 12.03 Military Disability Benefits
[1] Calculation of Military Disability Benefits
A disabled U.S. military retiree is entitled to retired pay from his or her military branch equal to the larger of amounts based on (1) length of service, or (2) percentage of disability.1 The entire amount of retired pay based on percentage of disability constitutes disability retired pay.
Even if the military branch bases retired pay on length of service, the pay is disability pay to the extent of the smaller amount based on percentage of disability. That is, if retired pay based on length of service exceeds retired pay based on percentage of disability, only the excess is not disability pay.2
As noted in § 12.02, above , a retiree may exclude from taxable income any reductions in retired pay to cover the cost of survivor benefits for beneficiaries.3 This exclusion applies to retired pay before any potential exclusion for disability pay.4
[2] Taxability of Disability Pay Received from a Branch of the U.S. Military
Disability retired pay from a branch of the U.S. military is nontaxable if it is payment for ''combat-related'' injuries or sickness resulting from active service.5 Combat-related injuries or sickness mean those (1) resulting from armed conflict, (2) incurred while engaging in extra-hazardous service, (3) suffered under conditions simulating war, or (4) caused by an instrumentality of war.6
Nevertheless, injuries or sickness need not be combat-related if the retiree was entitled to receive some of the disability payments before September 25, 1975. Nor are they required to be combat-related if, on September 24, 1975, the retiree was a member of a branch of the U.S. military (or had a binding contract to become a member).7
[3] Disability Payments from the Department of Veterans Affairs
Disability benefits paid to a retiree or survivors by the U.S. Department of Veterans Affairs (the ''VA'') are nontaxable even if the disability is not combat-related.8 However, if the retiree waives military retired pay to qualify for nontaxable VA benefits, the waived amount reduces the retiree's nontaxable disability pay before reducing taxable pay.9
On the other hand, if the VA award is retroactive, the retiree may be able to obtain tax refunds for prior tax years. The tax law extends the statute of limitations for a claim for refund until the end of the one-year period beginning on the later of the date of the VA's determination or May 22, 2008. However, the extension does not apply to tax years beginning more than five years before the date of the determination, or beginning before January 1, 2001. Nevertheless, it may be possible to recover the amount of prior income taxes withheld even for those years closed by the normal statute of limitations.10
Disability pay from a military branch is also nontaxable to the extent a retiree could successfully apply to the VA for the same benefits. The retiree need not actually file an application with the VA. Thus, the nontaxable portion of military retired pay is the greater of (a) the VA disability benefits the retiree could receive upon application (limited to the total amount of taxable and nontaxable military disability pay) or (b) nontaxable military disability pay determined without regard to potential VA benefits.11
[4] Refund of Costs of Survivor Benefit Coverage Due to VA Disability Offset
If a surviving spouse receives nontaxable VA disability benefits, the retiree's military branch may reduce the amount of the spouse's survivor benefits by an equal amount. In that case, the spouse will generally receive a refund of part of the amount the retiree previously paid for survivor benefits, i.e., a refund of the cost attributable to the reduction in the spouse's survivor benefits. The refund is generally taxable to the spouse (except for any portion of the cost the retiree paid in cash).12
[5] Coverage Outlays Not Recoverable Against Nontaxable Disability Benefits
As discussed in § 12.02[2], above, a retiree may have made coverage outlays to a military branch to pay for survivor benefits. If so, the retiree or beneficiaries may recover the outlays tax-free from military retired pay or survivor benefits. Fortunately, however, the tax law does not require the retiree to waste the tax benefit from the coverage outlays by recovering them from already nontaxable military disability pay.13
[6] Reduced Military Retired Pay During Civilian Government Employment
A retiree may receive a reduced amount of military retired pay if the retiree works as a civilian employee of the federal government after retirement from the military. In that case, the tax law also requires the retiree to reduce the nontaxable disability portion of retired pay by a percentage. The percentage is equal to the total reduction in retired pay divided by ''adjusted retired pay''. For this purpose, ''adjusted retired pay'' is the amount originally payable to the retiree after any waiver of pay to receive VA benefits and after any reduction in pay for the cost of survivor benefits.14
Example: Assume an individual retires from the military, and that the retiree's ''adjusted retired pay'' of $25,000 per year includes nontaxable disability pay of $5,000. Assume the military thereafter reduces the retired pay by $10,000 because of the retiree's work as a civilian government employee. Then, the retiree must reduce the amount of non taxable disability pay by 40 percent (from $5,000 down to $3,000). The retiree computes this percentage by dividing the total $10,000 reduction in retired pay by the adjusted retired pay of $25,000. (The retiree also reduces the amount of taxable retired pay by 40 percent, from $20,000 down to $12,000.)
FOOTNOTES:
1. 10 USC § 1401, 1402, 1402a. Different rules, beyond the scope of this book, may apply to temporary disability payments made to military personnel not yet retired.
2. 10 USC § 1403.
3. IRC § 122(a).
4. Treas. Reg. § 1.122-1(c)(2).
5. IRC § 104(a)(4), (b)(2)(C), (b)(3).
6. IRC § 104(b)(3).
7. IRC § 104(b)(2)(A), (B).
8. 38 USC § 5301(a).
9. Treas Reg § 1.122-1(c)(3).
10. IRC §§ 1341, 6511(d)(8); Strickland v Comm’r, 540 F2d 1196 (4th Cir 1976); Vercher v US, 2007 U.S. Dist. LEXIS 61844 (WD La 2007); Rev Rul 78-161, 1978-1 CB 31.
11. IRC § 104(b)(4); Grady v Comm’r, TC Memo 1989-55 (potential VA benefits may replace only military pay for personal injuries or sickness, i.e., taxable or nontaxable military disability pay).
12. IRC § 122(a).
13. Treas Reg § 1.122-1(b)(2)(iv).
14. 5 USC § 5531; Treas Reg § 1.122-1(c)(4),(d), Example (4).
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§ 12.04 The Thrift Savings Plan (TSP)
The Thrift Savings Plan (TSP) is a qualified retirement plan that allows active duty U.S. military personnel to make nontaxable contributions to the plan in lieu of receiving an equivalent amount of otherwise taxable military pay.1 In other words, military personnel may elect to have their military branch make pre-tax contributions (i.e., nontaxable contributions) to the plan from their military pay. The rules applicable to distributions from qualified retirement plans (as described in Chapter 2) apply to the TSP.2
FOOTNOTES:
1. 5 USC §§ 8431-8440(f).
2. IRC § 7701(j)(1).
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§ 12.05 Estate or Gift Tax Imposed on Survivor Benefits
Survivor benefits may become subject to gift or estate taxes. In addition, as beneficiaries report survivor benefits, they may become entitled to income tax deductions for portions of any federal estate tax imposed on the retiree's estate. See Chapter 18 for a more comprehensive explanation of the effect of gift and estate taxes on survivor benefits.