Taxation of Retired Military Disability Compensation
Understanding how retired military members' disability payments are taxed can be complex. This guide explains all of the regulations that pertain to this situation.
When excludable payments are made to a retired military individual, the payments are made by the Department of Veterans Affairs (VA) and an informational return (i.e., 1099-R) is not issued. The taxable portion of the retirement payments is paid by the Defense Finance and Accounting Services (DFAS) and included on a 1099-R. In other words, the non-taxable portion is not included on the 1099-R.
“ Example – Robert is retired from the military with a 30% disability. His annual military retirement is $40,000 of which $12,000 (30% of $40,000) is paid by the Dept. of Veterans Affairs, is not reported on a 1099-R and is not taxable income. His military retirement pay is reduced to $28,000 ($40,000 less the $12,000 amount paid by the VA), reported on a 1099-R and is fully taxable. ”
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CAUTION
Reducing a retired military individual’s 1099-R reported income by his or her disability percentage is INCORRECT. The disability portion is paid separately by the Dept. of Veteran’s Affairs and is not included in the 1099-R from the Defense Finance and Accounting Services (DFAS).
Retroactive Disability Determinations
When the VA determines that a veteran qualifies retroactively for disability compensation, all or part of the taxable retirement pay that was previously received is designated as non-taxable disability compensation, and the veteran is eligible for a refund of taxes previously paid on the retirement income. For initial awards, the retroactive portion is the disability compensation entitlement from the effective date shown on the VA award letter through the day before the reduction of retired pay. For increased awards, the retroactive portion is the difference between the increased award and the amount by which retired pay was reduced, from the effective date of the increased award as shown on the VA award letter through the day before the reduction of retired pay. The excludable amount may not exceed the monthly taxable retired pay for any given month.
When the retired pay is reduced after the effective date of the award, the retroactive portion applicable for the year of the reduction is excludable on that year’s return. Enter the retroactive portion as an adjustment to income on Form 1040, Schedule 1, line 24z, and attach an explanation. The DFAS suggests that a copy of the VA award letter and the DFAS-Cleveland Retiree Account Statement (DFAS-CL 7220/148) and, if received, a DFAS-CL waiver notice (DFAS-CL 1800/30) be included with the return. (DFAS-CL 1800/36, rev. 6/11)
To obtain a refund when retroactive disability compensation is awarded for a prior year, that year’s return will need to be amended. Until passage of the Heroes Act, veterans’ claims for refunds because of retroactive disability classification were subject to the same time period rules for filing claims as for all other reasons.
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Extended Claims - The time period for filing a refund claim, which is normally within three years of the filing of the tax return or within two years of the payment of the tax, is extended until one year after the date of the disability determination (if later than the time allowed under the general limitations period for filing a claim for refund or credit). However, the extended time period does not apply with respect to any tax year beginning more than five years before the date of the disability determination. (Code Sec. 6511(d)(8), as amended by the Heroes Earnings Assistance and Relief Tax Act of 2008, § 106(a))