35.2 Tax-Free Armed Forces Benefits

Caution

Withholding on Differential Wages Paid to Workers Joining Military

Employees who enlist or are called up to active military service for over 30 days may receive “differential wages” from their former employer to cover some or all of the difference between their military pay and the wages that were being received prior to joining the military. The differential wages are taxable and cannot be excluded as combat pay (35.4). Income tax must be withheld from the differential wages, but not FICA tax (Social Security and Medicare).

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The following benefits are not subject to tax:

• Combat pay (35.4).
• Living allowances for BAH (Basic Allowance for Housing). You may deduct mortgage interest and real estate taxes on your home even if you pay these expenses with BAH funds.
• BAS (Basic Allowance for Subsistence) living allowances.
• Housing and cost-of-living allowances abroad, whether paid by the U.S. Government or by a foreign government.
• VHA (Variable Housing Allowance).
• Family allowances for educational expenses for dependents, emergencies, evacuation to a place of safety, and separation.
• Death allowances for burial services, death gratuity payments to eligible survivors, and travel of dependents to burial site.
• Dislocation allowance, intended to partially reimburse expenses such as lease forfeitures, temporary living charges in hotels, and other expenses incurred in relocating a household.
• Temporary lodging expense allowance intended to partially offset the added living expenses of temporary lodging within the United States for up to 10 days and up to 60 days abroad.
• A moving-in housing allowance, intended to defray costs, such as for rental agent fees, home-security improvements, and supplemental heating equipment, associated with occupying leased space outside the United States.
• Travel allowances for annual round trip for dependent students, leave between consecutive overseas tours, reassignment in a dependent-restricted status, and transportation for you or your dependents during ship overhaul or inactivation.
• Defense counseling payments.
• ROTC educational and subsistence allowances.
• Survivor and retirement protection plan premium payments.
• Uniform allowances paid to officers and uniforms furnished to enlisted personnel.
• Medical or hospital treatment provided by the United States in government hospitals.
• Pay forfeited on order of a court martial.
• Education, training, or subsistence allowances paid under any law administered by the Department of Veterans Affairs (VA). However, deductible education costs must be reduced by the VA allowance.
• Adjustments in pay to compensate for losses resulting from inflated foreign currency.
• Payments to former prisoners of war from the U.S. Government in compensation for inhumane treatment suffered at the hands of an enemy government.
• Benefits under Servicemembers’ Group Life Insurance.
• Dividends on GI insurance. These are a tax-free return of premiums paid.
• Interest on dividends left on deposit with the Department of Veterans Affairs (VA).

Miscellaneous tax breaks for military personnel and their families.

The Heroes Earnings Assistance and Relief Tax Act of 2008 (HEART) extended certain tax breaks and provided some new ones to individuals in the military or to surviving family members.

Combat pay election for earned income credit.

The election to treat nontaxable combat pay (35.4) as earned income for purposes of the earned income tax credit (25.11) has been made permanent.

Distributions to reservists.

Reservists called to active duty for at least 180 days are not subject to the general 10% penalty for distributions before age 59½ from retirement plans and IRAs. They also are allowed in some cases to make withdrawals of unused benefits from a health flexible spending account. These rules are discussed further at 35.8.

State and local bonuses are tax free.

Some states and municipalities pay bonuses to active or former military personnel or their dependents because of service in a combat zone. Such payments may be excludable from gross income under the combat rules at 35.4. If such payments were reported as income in prior years, an amended return can be filed if the statute of limitations (usually three years from the return’s due date) has not yet expired (47.2).

Extended statute of limitations for disability determinations.

Usually, a taxpayer must file for a refund claim (47.2) within three years of the due date of the return on which the income was reported. Payments from the government based on a service-connected disability are tax free, while payments based on length of service are taxable. The Department of Veterans Affairs may take a long time to make a disability determination, with the result that taxpayers may include the payments as income. Then, when they receive a favorable determination, they can file an amended return to receive a tax refund. The HEART Act gives taxpayers until one year after the date of a disability determination to file a refund claim if this date is later than the three-year period of limitation.

Death benefits.

Beneficiaries who receive military death gratuities or payments from the Servicemembers’ Group Life Insurance (SGLI) program can roll these amounts over to a Roth IRA or Coverdell education savings account (ESA) within one year of receipt. The usual limits on contribution amounts and income limitations for Roth IRAs (8.20) and Coverdell ESAs (33.11) do not apply to these rollovers.

Veterans not taxed on payments from Compensated Work Therapy program.

In response to a 2007 Tax Court decision that held that payments made by the U.S. Department of Veterans Affairs (VA) to disabled veterans under the Compensated Work Therapy (CWT) program are tax-free veterans’ benefits, the IRS reversed position and announced that it no longer treats CWT payments as taxable pay for services. Under the CWT program, the VA provides vocational rehabilitation services to veterans who have been unable to work and support themselves. The VA contracts with private industry and government agencies to provide these veterans with therapeutic work that emphasizes work skills training.

Disability retirement pay.

Your disability retirement pay may be tax free if you are a former member of the Armed Forces of any country, the Foreign Service, the Coast Guard, the National Oceanic and Atmospheric Administration, or the Public Health Service (2.14). Tax-free treatment of disability retirement pay is retroactive to the date of the application for benefits. But Social Security disability payments made on account of a combat-related injury are taxable to the same extent as Social Security retirement payments (34.3).