One of the most common misconceptions service members have is that their military pension will be tax free income once they retire. This misconception is so prevalent that the IRS has previously reported that nearly half of the taxes owed by current and retired federal employees are owed by retired veterans.
Let that sink in.
So what should you know and do to avoid being one of the many military retirees in the unfortunate position that you have to pay uncle Sam backed taxes?
The first thing you need to recognize is that every penny of your military pension is taxable by the federal government. Your military pension will be treated like W2 income for the purposes of taxes. What's more is that some states will tax your military pension too. However, this is not the situation for all states and some states prorate how they tax military retirees based on a variety of factors. Much like our disjoint healthcare system, our state tax system is also inconsistent across the country. This is something to be mindful of when you are choosing where your home of record is or where you decide to put down roots after you retire from the military. The fact is that your pension may not go as far in one state as it does in another if the taxes are different.
Another common misconception I hear is when service members mistake compensatory disability for military pension money. Compensatory disability is not, emphasis on NOT, taxable income. So sometimes people will think that because their disability from the VA is not taxable then they will get their military pension tax free too. Unfortunately, this is not the case. You can be 100% disabled according to the VA and pay no taxes on that disability money while simultaneously receiving a pension for which you pay normal income taxes . You need to make sure you understand the difference between what money you are receiving from the government is and is not taxable.
It is also well known that a typical retiree will receive 50% of their pay as a pension. However, what is sometimes overlooked is that the military only counts your base pay when determining your pension compensation. For example, if you make $8,000 a month in total pay but your base pay is only $5,000 of that amount then your pension in retirement will be a monthly stipend of $2,500. You cannot include supplemental allowances in your pay when calculating your pension. That means no BAH, BAS, clothing allowances or other special duty pay.
One last consideration, and this one trips up a great number of people when they retire, is that the federal government has no obligation to communicate your taxable income to your employer. Why does this matter? Well it means you will likely not have enough of your pay withheld for taxes because neither DFAS nor your new employer know what the other is paying you. For example, let's say your employer pays you well enough that you are in the 24% marginal tax bracket and your retirement pension pays you well enough that you would fall into that same 24% marginal tax bracket without your day job, then you are likely going to owe a lot in taxes at the end of the year. This is the case because for some amount of your income you should have been withholding enough to account for the 32% marginal tax rate but you were likely only withholding enough to satisfy the 24% marginal tax bracket. As a result you may have had tens of thousands of dollars of income that should have been getting an extra 8% of taxes withheld.
There are three courses of action to take if this scenario applies to you. You can either increase your withholding directly through DFAS, ask your employer to withhold more money or make estimated payments to the IRS on a quarterly basis. There are pros and cons to all these methods but it is a good idea to pick one before you find yourself swamped in back due taxes.
If you or someone you know needs financial planning or advisory services related to this or any other topic please reach out. If we can't help you we will work to find someone who can.