Are Military Retirements Exempt from Taxes?

The IRS states that many retired military members are “surprised” at how much income tax they owe after leaving the military if they also have civilian employment. Since many retired military members are relatively young (under age 50) at the time of retirement, starting a second career is a natural progression. However, income from two sources, military retirement and the new job, will almost certainly move them into a higher tax bracket.

While federal tax on military retirement applies to most veterans, where a veteran lives also impacts his tax situation. That's because states vary considerably when it comes to taxing military retirement payments.

Federal Tax on Military Retirement

The IRS considers military retirement pay a pension, and taxes it as such. Pension income is taxed as ordinary income, so you will pay taxes on your military income according to your tax bracket. Because the IRS does not consider pensions as earned income, there is no Social Security or Medicare tax involved. The amount the military retiree pays to the Survivor Benefit Plan (SBP) is not taxable.

While military retirement pay based on age or service length is fully taxable as far as the federal government is concerned, military disability pay falls under a different category.

Each year, anyone who receives more than $10 from a retirement plan must use Form 1099-R to report retirement income on his federal return. The form includes the gross distribution of pension income, the taxable amount of the distribution and any amount withheld for tax purposes. The form also includes a code, identifying the type of pension plan.

When reporting military retirement pay to the IRS, do not include the SBP amount withheld to provide your spouse and children with survivor benefits. The IRS also has an interactive withholding calculator on its website to help military retirees determine their tax liability and adjust withholding accordingly. The IRS and Armed Forces Tax Council have a short video available explaining how military retirees can plan their taxes if they take a civilian job.

Veterans Disability Compensation

Those receiving veterans disability compensation are not usually subject to federal or state income taxes. However, much depends on the disability rating when it comes to military retirement pay. For those considered less than 50 percent disabled, every dollar of VA disability benefits reduces their military retirement pay by a dollar.

For those above a 50 percent disability rating, the VA disability compensation remains tax free while the military retirement benefits are still fully taxable. There are exceptions for those receiving Combat Related Special Compensation.

Veterans Benefits

Military retirees receiving VA benefits do not have to pay taxes on these benefits. Excludable veteran benefits include:

•         Training and education.
•         Home grants for wheelchair-bound veterans.
•         Motor vehicle grants for amputees or blind veterans.
•         Veterans’ insurance proceeds.
•         Dependent care assistance benefits.
•         Combat zone state bonuses.

The No Income Tax States

Nine states do not impose a personal income tax, so military retirement pay is not taxed. These states include:

•         Alaska.
•         Florida.
•         Nevada.
•         New Hampshire.
•         South Dakota.
•         Tennessee.
•         Texas.
•         Washington.
•         Wyoming.

New Hampshire and Tennessee do tax dividend and interest income. For most retirees, military or otherwise, this type of income is not that significant unless they are quite well-to-do.

States Taxing Military Retirement Pay

Currently, eight states do not exempt military retirement pay from taxes. These states include:

•         California.
•         Montana.
•         New Mexico.
•         North Dakota.
•         Rhode Island.
•         Utah.
•         Vermont.
•         Virginia.

Kiplinger calls these states the worst for military retirees, but much depends on the state’s actual tax rates. For example, while North Dakota taxes all forms of retirement pensions, including proceeds from IRAs, 401(k)s and similar employer-sponsored retirement plans, its overall tax rate is among the lowest in the nation.

Every military retiree’s situation differs, as each must take into consideration additional retirement income, the income of a spouse if applicable and the availability of jobs in the individual’s field if she wishes to continue working. That is why every military retiree should sit down with an accountant and crunch the numbers before determining the best state in which to retire. Of course, for military retirees who want to live near family members, that consideration may override taxation when it comes to choosing a state to call home.

Other considerations may include states authorizing preferences for veterans in private hiring, states receiving the most Department of Defense contracts, which often translates into veteran-related jobs and overall state job opportunities for veterans.

States with Special Military Retirement Pay Provisions

Thirteen states and the District of Columbia have special provisions when it comes to military retirement pay and taxes. These provisions include:

•         Arizona – where $2,500 of military retirement pay is exempt from tax.
•         Colorado – where up to $24,000 of military retirement pay is exempt from tax.
  
•         Delaware – where those under age 60 are eligible for a $2,000 military pay exemption, while those over 60 may exempt up to $12,500.
  
•         District of Columbia – where those age 62 and up may exempt $3,000 in military pay from tax.
  
•         Georgia – where only those age 62 and older, or permanently disabled, may exempt military pay from taxation. For those between ages 62 and 64, the exemption amount is $35,000, and it's $65,000 for those 65 and up.
  
•         Idaho – where, while those over age 65 are exempt from taxes on military retirement pay as well as those between the ages of 62 and 65 who are disabled, deductions are reduced for those also receiving Social Security or federal railroad retirement benefits.
  
•         Indiana – where military retirees may deduct the lesser of their military retirement pay or $5,000.
  
•         Kentucky – where military retirement taxation depends on when the individual retired. For those retiring before 1997, all military retirement is exempt. For individuals retiring after 1997, military retirement pay exceeding $41,110 is subject to tax.
  
•         Maryland – where the first $5,000 of military retirement pay is exempt. For those who are totally disabled or have a disabled spouse, or are over age 65, additional tax breaks are available.
  
•         Nebraska – where military retirees have a choice. Here, within two years of retiring, they must decide whether to choose a seven-year, 40 percent exemption, or a lifetime exemption of 15 percent.
  
•         North Carolina – where if the military retiree was vested in the retirement system for a minimum of five years as of August 12, 1989, retirement pay is not subject to state taxes. Those who do not qualify for this exemption may exempt up to $4,000 if filing singly and $8,000 if married filing jointly.
  
•         Oklahoma – where the state exemption on military retirement pay is either 75 percent or $10,000, whichever is greater. However, the exemption cannot exceed the taxpayer’s federal adjusted gross income amount.
  
•         Oregon – where some military retirees may qualify for the state’s federal pension subtraction.
  
•         South Carolina – where if the military retiree had at least 20 years’ service on active duty, he may exempt $3,000 in military retirement pay until age 65, at which time the exemption increases to $10,000.
  

States That Do Not Tax Military Retirement Pay

Twenty states do not tax military retirement pay per se, but they do impose a state income tax. These states are include:

•         Alabama.
•         Arkansas.
•         Connecticut.
•         Hawaii.
•         Illinois.
•         Iowa.
•         Kansas.
•         Louisiana.
•         Maine.
•         Massachusetts.
•         Michigan.
•         Minnesota.
•         Mississippi.
•         New Jersey.
•         New York.
•         Ohio.
•         Pennsylvania.
•         West Virginia.
•         Wisconsin.