Is My Military Retired Pay Tax Free if I have a VA Disability Rating? – NO!

Every year I have a handful of clients ask me if their military retired pay (a.k.a. pension) is tax free because they have a disability rating from the Department of Veterans Affairs (VA). When I ask why they believe their military pension is not subject to taxation they forward me “the email.” It is semi-official looking and seems to be from someone who ought to know what they are talking about. The email cites an IRS publication and sometimes (depending on which version you get) a court case.

It’s all twaddle. Your military retired pay is taxable income.

Like everything involving tax rules there are exceptions to the general rule. That is doubtless where the confusion originates. “The email” makes it seem like many more veterans qualify for the exception than do. The simple test to apply is this – do you have a written determination from the VA or your branch of the service specifying that your disability is combat-related. If that answer is ‘no” then you are paying taxes on your military retired pay. (If the answer is “yes”, you might still have to pay taxes on it, but you have no hope of being tax free without that official determination.)

Until recently I had to provide a long explanation to recipients of “the email,” some of whom ardently believe their retired pay was not taxable because they had a VA disability rating. I would have to explain that the court case did not apply, that IRS publications are not legally authoritative, and that the passages cited are being taken out of context. The explanation got much shorter recently, as one veteran took her case to the US Tax Court. The judge ruled against her, and his explanation sheds some light on the tax status of military retired pay.

You can read the full Tax Court Memo here.

T.C. Memo 2022-42; Tracy R. Valentine v. Commissioner filed April 28, 2022

Valentine is an Army veteran who was honorably discharged in 2002 after 22 years of active duty service. She had a disability rating of 60% that was increased to 90% effective May 1, 2016. For the first 4 months of 2016 she received VA disability payments of $1100 per month. For the remaining 8 months of 2016 she received $1700 per month in VA disability payments. The IRS does not dispute that these payments from the VA are tax free (excluded from income).

Valentine also received $23,801 from her Army-based retirement plan in 2016. She received a form 1099R from DFAS, reporting the entire amount as taxable. When Valentine filed her 2016 tax return she reported the taxable income from her military pension as $3,158, excluding the remaining $20,643 as not taxable income. The IRS disputed her claim that part of her military pension should be excluded from income and issued a Notice of Deficiency (NOD). Valentine exercised her right to challenge the NOD and petitioned the Tax Court for relief.

At Tax Court Valentine testified that IRC Section 104(a) and 104(b) entitle her to use the VA disability rating to exclude both the VA disability payments and a portion of her military pension from taxable income. Valentine represented herself at Tax Court and did not cite specific sub-paragraphs of the IRC to support her claim.

In his ruling Judge Gustafson provided some analysis of the tax code. There are two separate provisions in the tax code that could render a veteran’s military retired pay excludible from income. Under section 104(b)(2)(C) a veteran may exclude a portion of the distributions from income if they qualify as “amounts…received by reason of a combat-related injury”. Valentine did not provide any testimony or evidence at trial to indicate her disability rating was combat-related. Therefore section 104(b)(2)(C) does not apply.

The other provision is contained in section 104(b)(2)(D). A veteran may exclude a portion of the distributions from income equal to an amount they “would be entitled to receive as disability compensation”. There is legislative history supporting the court’s interpretation of this to mean that it does not apply if one is already receiving disability compensation from the VA. As Valentine was already receiving disability compensation from the VA, section 104(b)(2)(D) does not apply.

The Bottom Line

Bottom line: The US Tax Court ruled all the retirement distributions Valentine received are “properly includible in her gross income”. Military retired pay cannot be excluded from income solely because one has a VA disability rating. Valentine was also subject to penalties and interest on the tax owed for not reporting the income on her 2016 tax return.

I have had clients contact DFAS, explain they have a VA disability rating, and request the tax withholding on their military retired pay stop. When DFAS stops the withholding the veterans assume DFAS agrees that the pay is not taxable. That is not true. It simply means that DFAS will stop tax withholding on your military retired pay if you request it. When the 1099R is issued it will state that all the retired pay is taxable. Since the IRS also receives a copy of your 1099R, they will expect you to declare it on your individual income tax return and pay taxes on it. If you don’t, they will issue you a Notice of Deficiency and charge you penalties and interest for failing to report it.

I am a veteran with a VA disability rating. I want my military retired pay to be tax free. I am also a tax professional. If my military retired pay was tax free I’d know about it. If our military retired pay was tax-free I would be writing about it. My colleagues would be writing about it. The VA, VFW, DAV, and the American Legion would all be writing about it. The IRS would have pages of FAQs about it. You wouldn’t find out about it through an old forwarded email that tells a story too good to be true.

If you still have questions, the Military Financial Advisor’s Association has both tax professionals and financial planners with tax planning expertise that can help with your unique situation.

New VA Management of Education Debts

The Johnny Isakson and David P Roe, M.D. Veterans Health Care and Benefits Improvement Act of 2020 passed into law January 5, 2021. While the law is full of changes and expansions to the variety of GI Bill programs, this post will focus on changes VA management of education debts.

Students and schools can receive overpayments of benefits through withdrawing from classes, withdrawing from school, or from failing to pass classes. Prior to the passage of the most recent Veterans Health Care and Benefits Improvement Act, students that received the overpayment were typically assigned financial responsibility for the debt. The Department of Veteran’s Affairs would then collect directly from the students. That has changed, although, the VA is still working to implement changes to comply with the new law.

What you need to know

If you are using VA GI Bill Benefits to pay for college, changes to your enrollment impact your benefits. If you drop classes on or prior to the first day of classes and the VA has already paid the school, the school is responsible for repaying the VA. If you drop classes after the first day of school, the student is financially responsible for repaying the VA. If you drop below full time and have already received benefits, you will be responsible for repaying any over payment amounts.

The Big Change

The VA will no longer collect tuition and fee debts from students. Moving forward, the VA will collect debts from the school and the school will be responsible for collecting from the students. Schools will be the holder of the tuition and fee debt. Students will have to work directly with the school to repay tuition and fee debts. Students who owe money to the school need to be aware of how tuition and fee collections work in their state.

Books and Stipend Debts

The Post 9-11 GI bill generously includes a housing allowance and books and supplies stipend. Changes to enrollment, such as dropping below full-time status or withdrawing from enrollment result in debts owed to the VA. Don’t forget that changes made to enrollment, such as moving from full-time to half-time status, are applied retroactively to the start of the semester. There are exceptions to repayment for specific mitigating circumstances. There is also a 6 Credit Hour Exclusion to repayment. If you don’t have a mitigating circumstances exception and you have used your OTE, be prepared to repay benefit overpayments. It makes sense that as the benefits are paid directly from the VA to the student, the VA will still own the repayment debt. The VA will still collect the repayment debt directly from the student.

The Bottom Line

First, read those emails you get from the VA. They help you stay up to date on changes that directly affect your benefits. Secondly, if you have to withdraw from classes after the first day, be prepared to repay tuition and fees to the school. Third, if you fall below full time or withdraw from enrollment, be prepared to repay housing allowance and stipends directly to the VA.