Is Military Retirement Taxable If 100% Disabled?

While military retirement income is generally subject to federal taxes, Department of Veterans Affairs (VA) disability compensation is not. This distinction is important for veterans, particularly those with a 100% disability rating, as certain provisions allow portions of their military retirement to become tax-exempt.

Taxation of Military Retirement Pay

Military retirement pay is taxable income subject to federal income tax. This income is treated similarly to other pension or annuity payments. The Defense Finance and Accounting Service (DFAS) reports these payments on IRS Form 1099-R, which details the gross distribution and any taxable amount.

The federal government taxes military retired pay based on age or length of service. While state tax laws vary, many states offer full or partial exemptions for military retirement income.

Tax-Exempt Status of VA Disability Compensation

In contrast to military retirement pay, all disability compensation paid by the Department of Veterans Affairs (VA) is tax-free. This exemption applies regardless of the veteran’s income level or the origin of the disability. VA disability compensation is not considered gross income for federal tax purposes.

This tax-exempt status extends to various forms of VA benefits, including monthly disability payments, grants for adapted homes or vehicles, and dependent care assistance programs. The IRS automatically applies this tax break.

Recharacterization and Tax Exemption for Disabled Veterans

The intersection of military retirement pay and VA disability compensation involves specific mechanisms that can make a portion of retirement pay tax-exempt, particularly for disabled veterans. A common scenario involves a veteran waiving a portion of their military retired pay to receive VA disability compensation. The waived amount of military retired pay becomes tax-free because it is replaced by tax-free VA disability compensation.

Concurrent Retirement and Disability Pay (CRDP)

Concurrent Retirement and Disability Pay (CRDP) allows eligible veterans to receive both their full military retired pay and their full VA disability compensation without a reduction in either benefit. This applies to veterans with 20 or more years of service and a VA disability rating of 50% or higher, or those retired under specific medical provisions. Under CRDP, the VA disability portion remains tax-free, but the military retired pay portion is still taxable.

Combat-Related Special Compensation (CRSC)

Combat-Related Special Compensation (CRSC) offers another avenue for tax-free payments for veterans whose disabilities are combat-related. CRSC restores the tax-free portion of retired pay that was waived to receive VA disability compensation. It is a tax-free entitlement paid monthly for combat-related disabilities. Unlike CRDP, CRSC payments are tax-free, and veterans cannot receive both simultaneously; they must choose the one most financially advantageous. A 100% disability rating maximizes the amount of tax-free VA disability compensation received, which can significantly reduce or eliminate the taxable portion of military retired pay through these programs.

Claiming Tax Exemption and Adjusting Past Returns

For the current tax year, veterans should review their IRS Form 1099-R from DFAS, which reports military retirement pay. While the form reflects the taxable portion, veterans who receive tax-exempt VA disability compensation should ensure the correct taxable amount is reported. VA award letters provide official documentation of tax-exempt disability compensation, which can be cross-referenced with the 1099-R.

Veterans may need to amend past tax returns if they receive a retroactive disability rating or if they previously paid taxes on amounts now considered tax-exempt due to recharacterization. This is done using IRS Form 1040-X. Generally, a claim for credit or refund must be filed within three years from the date the original return was filed. However, if a veteran receives a retroactive service-connected disability rating determination, the statute of limitations is extended by a one-year period beginning on the date of the determination. Keep records, including VA disability rating documents, VA award letters, and any correspondence from DFAS or the VA regarding pay adjustments.