When you retire from the military, many things on the financial side of your life will change. Your tax picture will change a lot. One unique issue you may confront is the interaction of your military retirement pay and your VA Disability Compensation and how that interaction affects your tax bill.
By the time you've served 20 years in the military you've probably gotten a little bit "beaten up" and there is a high probability that you will qualify for VA Disability benefits. For those of you who are less than 50% disabled, those benefits will most likely cause a tax issue.
Taxation of Military Retirement and VA Disability Benefits
Military retirement pay is taxed as ordinary income, just like any other pension. VA disability compensation, on the other hand, is tax free. And there is the rub. If you are rated less than 50% disabled, your military retirement pay is reduced by one dollar for every dollar you receive in VA benefits. And...unless you are the one in a million military retiree, there is going to be some time between the time you retire and the time you start receiving your VA benefits. During that time, some of your income will be incorrectly counted as taxable income. It will also be incorrectly reported on your Form 1099-R (that is what you get instead of a W-2 when you're retired) as taxable income and you will pay more in income taxes than you should. The government/DoD won't give you much help.
There is a Solution
Unless your financial or tax advisor works routinely with retiring military members, there is a pretty good chance you'll need to point your advisor in the right direction or do this yourself. What you or your advisor will need to look at is Internal Revenue Rule 78-161. IRR 78-161 implements a court decision (Strickland versus Commissioner) where the court decided that you, as a retired member of the military, have the right to adjust the amount reported on your Form 1099-R to reflect the offset that should have been taken while your claim was being adjudicated.
You'll make this adjustment to your income as follows:
- You'll report your retirement income exactly as it is shown on your Form 1099-R
- You'll report the offset that should have been taken on the "other income" line as a negative number
- On the line where you take the offset, write "IRR 78-161"
If your claim was being processed across more than one tax year, you can file an amended return (1040-x) for the tax years for which you've already filed a return. There are limits to how long you have to file the return and I'll cover them in a future blog post.
Financial Results May Be More Than You Expect
You might be thinking to yourself, "More trouble than it's worth." That might not be true. It is going to depend on how much time passed before you receive your rating, your disability rating itself (again less than 50%), and how many dependents you have.
As an example, I had a client who was 30% disabled, had 4 dependents, including his spouse and had 3 months of no offset. The amount of the VA benefit was around $600 a month, so he could reduce his income by $1,800. I advised him of his right to amend his return to reflect the offset that should have been taken.
Now, this gets interesting. He was in the 25% bracket, so you would expect that he would get an additional refund of $450. He actually got closer to $700 back. How could that be? It was because by reducing his income he increased the amount of child credit for which he was eligible. About $250 worth of credit.
More To the Strickland Decision and IRR 78-161
There are more implications involved with IRR 78-161 and I'll write more on them here in the future. But as I mentioned, if your financial advisor doesn't routinely work with military members, you'll need to do some preliminary research to point him or her in the right direction.
Or...you can give us a call. We work with current and retired military officers every day.