Do You Pay Federal Taxes on Military Retirement Income?

Military retirement pay is an important source of income for veterans, but many are unsure how it is taxed at the federal level. Understanding these tax implications helps retirees plan their finances effectively and avoid surprises when filing returns.

Federal Classification

Military retirement pay is taxable income under IRS rules and is treated similarly to a civilian pension. The Defense Finance and Accounting Service (DFAS) issues Form 1099-R each year, reporting the total amount received and the taxable portion. Retired service members must include this income when filing federal tax returns.

The IRS categorizes military retirement pay as “nonqualified” under pension plan rules, meaning it does not receive the same tax treatment as employer-sponsored plans like 401(k)s. Unlike contributions to a traditional IRA or 401(k), military retirees do not receive a tax deduction for pension contributions during service, making the full amount generally taxable unless specific exemptions apply.

Military retirement pay is also subject to federal income tax withholding. Retirees can adjust their withholding preferences through DFAS by submitting Form W-4P, specifying the amount withheld from each payment.

Determining the Taxable Portion

The taxable portion of military retirement pay depends on whether any part qualifies for an exclusion. A key factor is whether the retiree receives tax-exempt disability compensation from the Department of Veterans Affairs (VA). Retirees eligible for both military retirement pay and VA disability compensation may waive a portion of their taxable retirement pay in exchange for tax-free disability payments, a process known as the VA offset.

For example, if a retiree receives $3,000 per month in military retirement pay but qualifies for $1,000 in VA disability compensation, they can elect to receive the $1,000 tax-free from the VA while reducing their taxable pension to $2,000.

Retirees with a VA disability rating of at least 50% may qualify for Concurrent Retirement and Disability Pay (CRDP), allowing them to receive full military retirement pay and VA disability compensation without an offset. In this case, the entire military pension remains taxable, while VA benefits remain tax-free.

The Survivor Benefit Plan (SBP) also affects taxation. SBP premiums are deducted from gross retirement pay before taxes, reducing the taxable portion. Since these premiums are paid with pre-tax dollars, beneficiaries who later receive SBP payments must report them as taxable income.

Withholding Elections

Military retirees can adjust federal income tax withholding from their pension payments through DFAS using Form W-4P.

A retiree’s withholding depends on filing status, number of dependents, and any additional tax elected for deduction. Since military retirement pay does not automatically account for other income sources, retirees receiving Social Security benefits, investment income, or wages from part-time work may need to adjust withholding to avoid underpayment penalties. The IRS imposes penalties if total withholding and estimated payments do not cover at least 90% of the current-year tax liability or 100% of the prior year’s tax, whichever is lower.

Retirees can use the IRS Tax Withholding Estimator to determine the appropriate amount to withhold. If adjustments are needed, a new W-4P can be submitted at any time, with DFAS typically processing changes within one or two pay cycles.

Disability Pay Differences

Military retirees receiving disability compensation are subject to different tax rules. Disability payments authorized under Title 38 of the U.S. Code are not taxable, as they are considered compensation for service-related medical conditions rather than deferred earnings.

For retirees qualifying for Combat-Related Special Compensation (CRSC), tax implications differ further. CRSC provides tax-free payments to those with verified combat-related disabilities. Unlike CRDP, which restores taxable military retirement pay, CRSC is not considered taxable income. Retirees approved for CRSC receive additional tax-exempt income without affecting their taxable pension.

Reporting on Returns

Military retirees must accurately report pension income when filing federal tax returns. DFAS issues Form 1099-R annually, detailing total retirement pay received and the taxable portion. Retirees should verify that the amounts listed align with their actual payments to avoid discrepancies that could trigger an IRS inquiry.

When entering military retirement pay on a tax return, retirees must include the taxable amount in the “Pensions and Annuities” section of Form 1040. If any portion of the pension is excluded due to VA disability compensation or CRSC, only the taxable portion should be reported. Errors in reporting can lead to underpayment penalties or delays in processing refunds.

Retirees who itemize deductions may be able to deduct certain expenses related to military service, such as unreimbursed medical costs, which can help reduce taxable income. Keeping detailed records of retirement-related income and deductions ensures compliance with IRS regulations.

State Tax Distinctions

While military retirement pay is subject to federal taxation, state tax treatment varies. Some states fully exempt military pensions, while others tax them partially or in full.

States such as Florida, Texas, and Nevada do not impose a state income tax, meaning military retirees residing there owe nothing on their pensions at the state level. Other states offer partial exemptions or deductions based on age, length of service, or disability status.

For example, North Carolina exempts military retirement pay for those who served at least 20 years or were medically retired. Indiana provides a phased-in exemption that increases annually. Some states allow retirees to exclude military pensions from taxable income if they receive Social Security benefits.

Retirees should review their state’s tax laws and consider how residency choices affect their overall tax burden. Consulting a tax professional or using state tax agency resources can help retirees optimize their tax situation.