Is Medical Retirement Taxable? How Federal Taxes Apply

Medical retirement provides financial support when an individual can no longer work due to a permanent medical condition. The tax treatment of these benefits depends on several factors, including the payment source, the reason for disability, and how the benefit is structured.

General Tax Treatment of Medical Retirement

Medical retirement payments are considered taxable income, similar to wages or a regular pension. This applies to most employer-sponsored disability retirement plans and some government plans. For tax purposes, medical retirement refers to payments received because an individual is unable to perform their job due to a permanent physical or mental condition, often occurring before reaching the normal retirement age.

The source of the payment and the specific reason for the disability influence its tax status. If the payments are from a plan where the employer paid all the costs, or if the employee’s contributions were made with pre-tax dollars, the entire amount received is taxable. These payments are included in gross income unless specific conditions for exclusion are met.

Tax-Exempt Medical Retirement Payments

Certain medical retirement payments are exempt from federal income tax under specific circumstances. Payments from the Department of Veterans Affairs (VA) for service-connected disabilities are not taxable. This includes disability compensation and pension payments made to veterans or their families under laws administered by the VA, as outlined in Title 38, U.S. Code, Chapter 11.

Military disability retirement pay can also be excluded from income if certain conditions are met:
The individual was retired for combat-related injuries, meaning a personal injury or sickness directly resulted from armed conflict.
The individual would be entitled to receive VA disability compensation, even if they choose military retirement pay instead.
The individual was on the retired list before September 25, 1975.
The payments are for injuries from active service in the armed forces, based on a percentage of disability, as outlined in 26 U.S. Code § 104(a)(4).
If a service member’s retirement pay is retroactively converted to VA disability benefits, they may be eligible for a tax refund on previously taxed amounts.

Some disability payments to public safety officers may also be excluded from income. Payments received as compensation for personal injuries or sickness incurred during employment, similar to workers’ compensation, may be exempt from federal income tax, as indicated by Revenue Ruling 85-105. Additionally, retired public safety officers can elect to exclude up to $3,000 annually from their qualified governmental retirement plan distributions if these amounts are used to pay for accident, health, or long-term care insurance premiums. This exclusion, authorized by 26 U.S. Code § 402(l) (Section 845 of the Pension Protection Act of 2006), requires the funds to be paid directly from the pension plan to the insurance provider.

The reason for the payment, whether for a service-connected disability or a general inability to work, determines federal tax exemption, not merely the label of “medical retirement.”

Calculating the Taxable Portion

When medical retirement payments are not entirely tax-exempt, calculating the taxable portion involves determining your “cost basis.” If you contributed after-tax dollars to your employer’s disability retirement plan, these contributions establish a cost basis. This amount can be recovered tax-free over the expected payment period, reducing the income subject to tax.

To calculate the non-taxable portion, individuals use the Simplified Method. This method is used for payments from qualified retirement plans, where a portion of each payment is a tax-free return of your cost. It involves dividing your total cost by the number of anticipated payments based on your age at the annuity starting date. Your plan administrator can provide information about your cost basis and the calculated tax-free amount. The portion of each payment exceeding this tax-free amount is taxable income.

For nonqualified plans, the General Rule may apply, which uses life expectancy tables to determine the tax-free portion.

If you retired on disability, your payments may initially be treated as wages for tax purposes until you reach your employer’s minimum retirement age. At that point, the payments transition to being taxed as a pension or annuity, allowing for the recovery of any cost basis.

Reporting Medical Retirement on Your Tax Return

The taxable amount of medical retirement payments is reported on your federal income tax return. Most medical retirement payments are reported to you on Form 1099-R, “Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.” This form shows the gross distribution in Box 1 and the taxable amount in Box 2a. Box 7 of Form 1099-R often contains a distribution code, with “3” indicating a disability payment.

The taxable portion of your medical retirement payments is reported on Form 1040. If you are below your employer’s minimum retirement age, some disability payments might be reported as wages on Line 1 of Form 1040. If you have reached or passed the minimum retirement age, or if your payments are treated as a pension, the taxable amount is reported on Lines 5a and 5b of Form 1040.

For non-taxable payments, such as VA disability benefits, you do not need to report them on your tax return. If you receive a Form 1099-R that includes non-taxable amounts, you can enter the gross amount in Box 5a and the excluded amount in Box 5b. Keep thorough records, including official letters from the VA, military orders, or plan documents, to support the tax-free nature of your payments.