2.14 Disability Pensions
Disability pensions financed by your employer are taxable wages unless they are for severe permanent physical injuries that qualify for tax-free treatment (3.3), they are tax-free workers’ compensation (2.13), or they are tax-free government payments as discussed in this section.
Taxable disability pensions are reported as wages until you reach the minimum retirement age under the employer’s plan. After reaching minimum retirement age, payments are reported as a pension (7.25).
If you receive little or no Social Security and your other income is below a specified threshold, you may be eligible to claim a tax credit for disability payments received while you are under the age of 65 and permanently and totally disabled (34.7).
Injury or sickness resulting from active military service.
Disability pensions for personal injuries or sickness resulting from active service in the armed forces are taxable if you joined the service after September 24, 1975.
Military disability payments are tax free if before September 25, 1975, you were entitled to military disability benefits or if on that date you were a member of the armed forces (or reserve unit) of the U.S. or any other country or were under a binding written commitment to become a member. A similar tax-free rule applies to disability pensions from the following government agencies if you were entitled to the payments before September 25, 1975, or were a member of the service (or committed to joining) on that date: The Foreign Service, Public Health Service, or National Oceanic and Atmospheric Administration. The exclusion for pre–September 25, 1975, service applies to disability pensions based upon percentage of disability. However, if a disability pension was based upon years of service, you do not pay tax on the amount that would be received based upon percentage of disability.
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VA pensions.
Disability pensions from the Department of Veterans Affairs (VA) are tax free. If you retire from the military and are later given a retroactive award of VA disability benefits, retirement pay during the retroactive period is tax free (other than a lump-sum readjustment payment upon retirement) to the extent of the VA benefit (see the first Law Alert in this section).
If a veteran receives a VA pension for a military service disability, and also disability benefits from the Social Security Administration, the VA benefits are tax free but the Social Security payments may be taxable (34.2).
Pension based on combat-related injuries.
Tax-free treatment applies to payments for combat-related injury or sickness that is incurred as a result of any one of the following activities: (1) as a direct result of armed conflict; (2) while engaged in extra-hazardous service, even if not directly engaged in combat; (3) under conditions simulating war, including maneuvers or training; or (4) that is caused by an instrumentality of war, such as weapons.
Social Security disability benefits.
Disability benefits from the Social Security Administration (SSA) are treated as regular Social Security retirement benefits that may be taxable (34.2).
In one case, a veteran who received disability benefits from the SSA as well as a disability pension from the Department of Veterans Affairs (VA) for cancer caused by exposure to Agent Orange during the Vietnam War tried to exclude both benefits from income. The IRS did not dispute the exclusion for the VA payments, but it held that the SSA disability benefits were subject to tax as if they were Social Security retirement benefits. The Tax Court and the Second Circuit Court of Appeals rejected the taxpayer’s argument that his SSA disability benefits were excludable as amounts received for personal injuries/sickness resulting from active military service. The Second Circuit held that the military service exclusion is not applicable for SSA disability payments because they are a wage-replacement benefit based on the number of quarters of Social Security coverage, and are payable whether or not the disability arose from military service.
Terrorist attacks or United States military actions.
Tax-free treatment applies to disability payments received by any individual for injuries incurred as the direct result of a terrorist attack against the United States or its allies. The exclusion also applies to disability income received as a direct result of a military action involving U.S. Armed Forces in response to aggression against the United States or its allies.
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