Servicemembers Get Special Tax Treatment
By Mark Luscombe
Spring 2007
In general, United States tax laws apply equally to civilians and members of the military. But Congress continues to pass laws to make sure that people don’t suffer from a tax point of view as a result of their military service.
Normally, military pay is taxable. This includes compensation with all sorts of names: active duty pay, reserve training pay, enlistment or re-enlistment bonuses, incentive pay, readjustment pay, and travel and per diem allowances.
Pay for service in a combat zone is an exception. All compensation for active service for any month in which a servicemember serves in a combat zone is exempt from income tax, up to the highest rate of enlisted pay ($6,724.50 per month in 2006). So if someone begins service in a combat zone on the last day of January and leaves it on the first day of December, the entire year’s pay is exempt.
Although combat pay is not considered “earned income” since it is not taxed, the Working Families Tax Relief Act of 2004 allows military members to count combat pay earned in 2005, 2006 and 2007 as earned income for determining the earned income tax credit and the child tax credit.
Combat Pay And IRAs
The Heroes Earned Retirement Opportunity Act of 2006 allows military personnel to count combat pay as earned income for the purpose of making contributions to traditional and Roth IRAs. The Act allows people who were unable to make an IRA contribution in 2004 and 2005 – because combat pay was not considered earned income in those years – to make up for it. However, they must make the contributions before May 29, 2009 (three years from the date the President signed the Act). They can also amend their tax returns for the years in question, within one year of the date of the new contribution, to receive a refund or a credit against their current taxes.
As a result of the Pension Protection Act of 2006, military personnel called to active duty will be allowed to make penalty-free withdrawals from IRAs, 401(k)s and similar tax-advantaged plans. In addition, they will have two years after the end of their period of service to repay the distribution into the plan, thus avoiding income tax, as well as the 10 percent penalty, on the withdrawal. The liberalized rules only apply to those called to service after Sept. 11, 2001, and before Dec. 31, 2007. Congress may extend this provision to cover additional years, but just when they’ll do that and for how long is anyone’s guess.
Extra Time To File
Members of the military who are on duty outside the U.S. or Puerto Rico but not serving in a combat zone have until June 15 to file their taxes. Interest will accrue from the normal due date until the time of payment, however.
If a military member is serving in a designated combat zone, deployed in a “contingency operation” or hospitalized outside the U.S. due to an injury received while serving in a combat zone or contingency operation, the due date of the servicemember’s return is postponed for the period of the combat service or hospitalization plus 180 days. No interest or penalties will be assessed.
The combat zone/contingency operation filing extension (which includes service in qualified hazardous duty areas) also applies to other tax-related time limits. This includes paying income and estate taxes, instituting Tax Court proceedings, filing refund claims, making contributions to qualified retirement plans and taking distributions from IRAs.
Taxpayers should write ‘Combat Zone’ across the top of returns and documents to bring these items to the immediate attention of the IRS or the Tax Court.
State Rules Vary
The rules for federal taxation of military pay and benefits can be complex, but at least they apply to all uniformly. Not so with the states. Many states with an income tax use taxable or adjusted gross income from the federal return as a starting point in calculating the state tax. In those cases, items excluded for federal purposes normally also escape taxation at the state level, but not all states follow this practice.
Some states exempt combat pay, some exempt pay for Guard and Reserve training, some exempt all military pay, some exempt a certain amount and some tax all of it. Fortunately, the web pages for many states’ departments of revenue address how military pay is taxed. But anyone with doubts should consult a qualified tax professional with a knowledge of the specific state’s rules.
# # #
Mark Luscombe, Cmdr. USNR (Ret.), J.D., C.P.A., is principal federal tax law analyst at CCH, a Wolters Kluwer business and a leading provider of tax and accounting law information, software and services. Visit www.cchgroup.com.