IRS Publication 525: Military Retirement Pay Tax Rules Explained

Understanding how military retirement pay is taxed helps retirees and their families plan their finances. The IRS provides guidance in Publication 525, detailing what portions of military retired pay are taxable and any applicable exclusions.

Tax treatment varies based on factors like disability status, combat-related compensation, and survivor benefits. Understanding these distinctions helps veterans and their beneficiaries maximize tax savings.

Military Retired Pay

Military retired pay is taxable at the federal level. The Defense Finance and Accounting Service (DFAS) issues Form 1099-R annually, detailing the taxable portion of retirement pay, which is required for filing federal income taxes.

The taxable portion depends on service history and pay calculation method. Those who entered service before September 8, 1980, have retirement pay based on final basic pay. Those who joined after use the High-3 system, which averages the highest 36 months of basic pay. These methods affect total taxable income, as different formulas determine monthly payments.

Federal income tax withholding (FITW) applies automatically unless a retiree submits Form W-4P to adjust it. Some states tax military retirement pay, while others offer full or partial exemptions. Florida, Texas, and Nevada do not tax retirement income, while California fully taxes it. Retirees should check their state’s tax laws.

Reserve and National Guard Retirements

Retirement benefits for Reserve and National Guard members differ from those of active-duty personnel due to how service time is calculated. Instead of requiring 20 years of active service, Reserve and Guard members earn retirement points through drill attendance, annual training, and active-duty mobilizations. A total of 2,920 points equates to 20 years of active service.

Unlike active-duty retirees, who begin receiving payments immediately, Reserve and Guard retirees must wait until age 60 unless they qualify for early retirement due to active-duty service under Title 10 orders. A 2008 provision allows members to reduce their retirement age by three months for every 90 days of qualifying service in a fiscal year, but not below age 50.

Tax treatment follows federal guidelines, with income tax withholding applied unless the retiree opts out. Some states offer additional tax benefits. Pennsylvania and Wisconsin exclude this income from taxation, while North Carolina provides deductions based on years of service or income thresholds.

Disability Retirement Provisions

Military retirees who qualify for disability retirement receive compensation based on their medical condition rather than years of service, affecting taxation. The Department of Defense (DoD) determines eligibility through a medical evaluation board. Approved retirees are placed on either the Temporary Disability Retired List (TDRL) or the Permanent Disability Retired List (PDRL), depending on the severity and stability of their condition. A minimum disability rating of 30% is required.

Taxation depends on whether the retiree qualifies under specific exclusions in the Internal Revenue Code. Under 26 U.S. Code 104, disability retirement pay is excluded from taxable income if the condition resulted from active-duty service or was determined by the Veterans Affairs (VA) to be service-connected. Veterans meeting these criteria do not owe federal income tax on disability retirement benefits. However, if the retirement is based solely on years of service rather than a medical determination, standard military retirement tax rules apply.

Retirees on the TDRL undergo periodic medical re-evaluations to determine whether they remain on the list, transition to the PDRL, or are separated. If a retiree is removed from the TDRL and receives a lump-sum disability severance, the tax treatment varies. Severance pay is typically taxable unless the disability was combat-related or qualifies for an exclusion under 26 U.S. Code 104. Veterans who had taxes withheld from severance but later receive a VA disability determination may be eligible for a refund by filing an amended return using IRS Form 1040-X.

Combat-Related Compensation

Service members injured in combat operations, hazardous duties, or training exercises may qualify for tax-free payments under programs designed to compensate for service-incurred disabilities. Combat-Related Special Compensation (CRSC) provides monthly payments to eligible retirees with combat-related disabilities, allowing them to receive both military retirement pay and VA disability compensation without offset. CRSC is not taxable under 26 U.S. Code 104, as it is classified as compensation for injuries sustained in armed conflict or hazardous service.

To qualify, retirees must have a VA-rated disability of at least 10% directly linked to combat conditions, including injuries from enemy action, simulated combat exercises, or exposure to hazardous materials. The amount received is based on the percentage of the combat-related disability and cannot exceed the portion of retirement pay previously reduced due to VA compensation. Since CRSC is not subject to federal income tax, recipients must ensure they properly account for these payments when filing tax returns, as they will not appear on Form 1099-R issued by DFAS.

Survivor Benefit Plan Deductions

Military retirees can enroll in the Survivor Benefit Plan (SBP) to provide financial security for dependents. This program allocates a portion of retirement pay to a surviving spouse or other eligible beneficiary. The cost of SBP coverage is deducted from retirement pay before taxes, reducing taxable income.

The cost is based on a percentage of the selected base amount of retired pay, typically up to 6.5%. Retirees who opt for full coverage have a higher deduction, but this also increases the annuity for beneficiaries. If a retiree later discontinues SBP participation, deductions cease, but prior contributions are not refunded.

Surviving spouses who receive SBP payments must report them as taxable income. However, they may qualify for tax relief if they also receive Dependency and Indemnity Compensation (DIC) from the VA. The SBP-DIC offset, which previously reduced SBP payments by the amount of DIC received, was fully eliminated in 2023, allowing survivors to collect both benefits without reduction.

Guidance from IRS Publication 525

IRS Publication 525 explains the tax treatment of military retirement pay, including taxable and non-taxable components. It details how different types of compensation—such as disability retirement, combat-related benefits, and survivor annuities—should be reported on federal tax returns.

For retirees receiving multiple forms of military-related compensation, the publication clarifies how to report each type separately. Those who qualify for both VA disability compensation and military retirement pay must follow specific reporting guidelines to avoid errors. The publication also provides instructions on amending past returns if a retiree later qualifies for tax-exempt disability pay. Since tax laws change, retirees should review the latest version of Publication 525 each year or consult a tax professional to ensure compliance.