Is Military Pension Taxable (Answered)

There are a number of tax breaks afforded to those in the military.

This includes collection holds on unpaid taxes owed by members of the military to laws that exempt certain income from tax altogether.

The exemption from paying tax on military pay for injuries is an example. The recent Valentine v. Commissioner, T.C. Memo. 2022-42, case provides an opportunity to consider this exclusion.

Facts & Procedural History

The taxpayer served in the U.S. Army. She was honorably discharged in 2002 and started receiving monthly disability payments from the Department of Veterans Affairs.

In 2014, she received $1,100 per month and the VA determined that her combined “service-connected” disability rating was sixty percent. Her payment and rating increased from 2014 to 2019.

The IRS agreed that these disability payments were not taxable. The focus of the case was on the retirement distributions.

The taxpayer also received distributions from her Army-based retirement plan. The U.S. Department of Defense Accounting and Finance Services (“DOD”) issued a Form 1099-R to signify that these payments were taxable.

The case was for the 2016 tax year. The taxpayer did not file a tax return, so the IRS prepared a tax return for her.

The taxpayer then hired a tax return preparer that showed that she was due a refund. The tax return seems to have reported a refund due to the taxpayer not including the full amount of the retirement distributions. The DOD had withheld taxes on the distributions, so by not reporting the full distributions as income, the tax return reported that a portion of the withheld taxes should be paid back to her.

The question for the court was whether the full retirement distributions were taxable.

Tax Free Combat and Disability Distributions

Our tax laws provide a number of tax breaks for military personnel.

As relevant to this case, Section 104 sets out two categories of income that are tax exempt.

The first exemption is for amounts received by an individual as disability income attributable to injuries incurred as a direct result of a terroristic or military action. This exclusion was not part of the case.

The second exemption is for amounts received as a pension, annuity, or similar allowance for personal injuries or sickness resulting from active service in the armed forces of any country or in the Coast and Geodetic Survey or the Public Health Service, or as a disability annuity payable under the provisions of section 808 of the Foreign Service Act of 1980. It does not cover Social Security payments.

This second exception is limited to:

1. Members of the military or a reserve component,
2. Military personnel who receive funds due to a combat-related injury, or
3. Absent receiving disability, those would be eligible to receive disability compensation from the VA.

This case focuses on items # 2 and # 3 as the taxpayer apparently was not a member of the military or reserve.

Combat-Related Injury

In this case, the court started with the question as to whether the retirement distribution was paid for a combat-related injury. The court noted that there was no evidence that the payment was related to combat.

Ms. Valentine made no showing that the Army or the VA ever determined that she had a “combat-related injury”. Rather, the letters Ms. Valentine received from the VA detail her “service-connected disability compensation” (emphasis added), without reference to “combat”.

This type of evidence may have included a statement in her tax court petition describing the combat-related injury. It could have included letters or any other documentation that she served in combat or possibly even in a combat zone while in the military. It might have even included testimony from herself or others about this.

The court noted that the taxpayer had provided some statements about combat, but since she was representing herself, she had to do so under oath:

After Ms. Valentine’s pretrial statement that used the word “combat”, the Court explained her need to give, as sworn testimony, all the information on which her case depended: “You may feel like a few moments ago you already explained your retirement disability situation, and you may feel like you’re done, but I’m sad to inform you you’re not. Sitting there at that table [representing herself pro se], you are your lawyer. You’re not giving testimony when you’re there. You’re explaining your position. And in a moment, we’re going to have you come up and take the oath, and then give testimony that’s sworn testimony and that can be relied on as evidence. And so make sure that when you’re giving your testimony, you go ahead and tell the whole story. Don’t suppose that what you said a moment ago will substitute for that.” Her testimony thereafter did not mention “combat”.

Absent this type of evidence, the court did not find a combat-related injury.

Those trying to qualify under this provision should note that the Code does not say that the injury has to be a physical injury. Thus, a mental or emotional injury may suffice. The Code also does not require the combat to be in an actual war. It could, for example, be in a special military exercise in a foreign country. There just has to be some evidence, even testimonial evidence, that the injury was sustained due to some type of combat.

No Double Dipping

The court then considered whether the retirement distributions were partially tax free under item # 3, above.

The taxpayer apparently applied her disability rating to the retirement distribution and concluded that only the part above her VA disability rating was taxable.

The court did not agree with the taxpayer. It noted that the taxpayer was already receiving disability payments from the Army. The law does not allow the taxpayer to double dip, i.e., she cannot get tax free disability payments and also treat retirement distributions as tax free. It is one or the other.

The Takeaway

Those receiving disability payments from the military or retirement distributions should review these rules. Amounts received for injuries are generally not taxable. The same goes for amounts received on account combat-injuries.

As this case shows, this can even include retirement plan distributions if the taxpayer was disabled and is not receiving disability payments.

Evidence that the taxpayer served in a combat-zone and/or sustained injuries or would qualify for a disability rating can result in retirement distributions being tax free. This could substantially reduce the amount of tax due on retirement payments. This is an area where advanced tax planning can help.