A transition from active duty is a turbulent time. Whether you are retiring, separating or going to the Reserves, there are a lot of financial impacts to your life. It’s important to take some time to recognize what those impacts look like. If you know the tax consequences before your transition, then you’ll make more informed financial decisions. Below are nine ways your tax situation might change.
Tax Consideration No. 1: Loss of Allowances and Tax Exclusions
This is probably the most commonly recognized tax impact. Most service members realize they have to make considerably more as civilians to equal the amount of after-tax dollars they see in the military.
For example, based on 2022 figures, an unmarried E-5 over six years living in Norfolk, Virginia, would earn in one year:
- Base pay: $3,601.80 X 12: $43,221.60 (taxable)
- Basic allowance for housing: $1,725 X 12: $20,700 (non-taxable)
- Basic allowance for subsistence: $460.25 X 12: $5,523 (non-taxable)
- Total compensation: $69,444.60
- Total taxable compensation: $43,221.60
It’s difficult to calculate an exact tax liability without a fully developed case study. However, there are a couple of things worth pointing out here:
- How much compensation is tax-free: There’s more than $25,000 in tax-free allowance in this person’s compensation. That almost one-third of this compensation is tax-free should highlight how powerful this benefit is. As you include incentive pays and bonuses, this number might change. However, it’s impossible to overstate how important this benefit is.
- Marginal tax bracket: In this case, the E-5 in question would be at the top end of the 12% marginal tax bracket. However, if the total compensation were taxable, that person would then be in the 22% tax bracket. This means that for every dollar of additional income, this person would be paying an additional 10% in taxes. Your marginal tax bracket also affects the calculation of capital gains tax.
The related loss of combat zone tax exclusion amplifies this difference. Many service members find themselves in the 10% or 12% tax bracket during deployment years and the 22% or 24% tax bracket when they’re not deployed.
Tax Consideration No. 2: Section 121 Tax Exclusion
Section 121 of the tax code allows you to exclude up to $250,000 ($500,000 for a married couple filing jointly) on your home sale. In order to do this, you have to meet certain ownership and use requirements. The use requirement states that you must have lived in the home for two of the previous five years (730 days or more) in order to qualify.
However, there is a clause known as “stop the clock.” This allows active-duty members to suspend the use requirement up to 10 years if they receive orders to a duty station at least 50 miles from their homes.
This clause only applies to active-duty military, so you’ll want to consider the tax impact of selling before and after transition. This holds especially true for a home that’s been converted into a rental and that you do not intend to move back to.
Tax Consideration No. 3: Terminal Leave Sell-Back
If you’re in a position to take terminal leave, you’ll have to decide whether to take your leave or sell it back. There are many non-tax factors playing into this decision. You might have a compelling job opportunity, need the time to relocate or return to school.
However, you should keep in mind two things about selling back your terminal leave:
- You only receive compensation on selling your base pay. Your terminal leave sell back does not include allowances, bonuses or other pays.
- Any terminal leave that you sell back is taxable.
Tax considerations shouldn’t be your primary focus on whether you sell or take your terminal leave. However, you should keep in mind the tax impact of your decision.
Tax Consideration No. 4: Change in State Income Taxes
Most people know that once you establish a residence in a state, you can keep that state as your home of record. This applies even when you PCS from that state. Most people also know that the Military Spouses Residency Relief Act extends this privilege to military spouses. For people who live in a state with no income taxes, this is a tremendous tax benefit. This allows for two benefits:
- The obvious benefit of not having to pay state income tax.
- The ability to automatically deduct state sales tax on Schedule A of your tax return. Normally, the IRS allows you to deduct either state income tax or state sales tax on Schedule A of your tax return, not both. If you’re in a position where you don’t have to pay state income tax, then you can automatically deduct sales tax. This is especially great in years in which you incur big expenses or when you live in a state with higher sales tax.
Keep in mind that as you transition from active duty, you’re stuck with the tax laws of the state you live in. To make it more confusing, some states treat pensions differently for tax purposes than other types of income, and some states don’t tax military retirement pay.
Tax Consideration No. 5: Change in Residency Requirement for Earned Income Credit
For those of you who might file and claim earned income credit (EIC) on your tax returns, there is a clause allowing active-duty members to live OCONUS with their child and remain eligible for EIC. However, the eligibility requirement for EIC dictates that: “Your child must have lived with you in the United States for more than half of the tax year.” This means that if you transition from active duty and remain OCONUS, you will no longer meet this requirement.
Tax Consideration No. 6: Community Property Treatment of Active-Duty Pay
In the United States, there are nine community property states:
- Arizona
- California
- Idaho
- Louisiana
- Nevada
- New Mexico
- Texas
- Washington
- Wisconsin
There are also states and jurisdictions that allow for community property treatment of income and property: Alaska, Tennessee and Puerto Rico.
For those of you who live in community property states, the following IRS statement applies: “Active military pay earned while married and domiciled in a community property state is also community income. This income is considered to be received half by the member of the Armed Forces and half by the spouse.”
However, if you retire to a community property state, all this changes. Community property laws generally state that military retirement pay is treated as community property to the extent that it was earned while domiciled in a community property state. For example, if a service member served 20 years active duty, and was married in a community property state for 10 years, then 50% of the pension would be treated as community property.
While tax treatment of community property is outside the boundaries of this article, it is important to point this out. If you think this might apply to you, you should consult with a tax professional in your state. A tax professional can help you determine the treatment of your retirement pay.
Tax Consideration No. 7: Tax Filing Deadlines
Active-duty members deployed to a war zone, qualifying service outside of a war zone or to a contingency operation outside of a war zone are automatically eligible for extensions of tax filing deadlines. Specifically, this allows you to extend your deadline to 180 days after:
- Your last day in a combat zone, qualifying service or contingency operation
- Any hospitalization that directly results from one of these deployments
However, this eligibility ends upon the end of active service. This is particularly important for service members who make frequent deployments and who have several years of filing tax returns under these conditions.
Tax Consideration No. 8: Unreimbursed Moving Expenses
For tax years after 2017, only military members on active duty can deduct unreimbursed moving expenses, which must be incurred in conjunction with a permanent change of station (PCS) move. This tax deduction is calculated on IRS Form 3903 and is reported as an ‘above the line’ deduction on Schedule 1 of your Form 1040.
When you leave active duty, you may claim unreimbursed moving expenses related to your final PCS move (up to 1 year after leaving active duty, or otherwise allowed under the Joint Travel Regulations). After this, you may no longer claim unreimbursed moving expenses as a tax deduction.
Tax Consideration No. 9: Traditional IRA Contributions
There are two impacts here:
- Deductibility of IRA contributions. There are different rules for determining whether a traditional IRA contribution is deductible. If you’re not covered under an employer’s retirement plan, you can deduct your traditional IRA contributions, regardless of your income. Active-duty members are considered to be covered under an employer’s retirement plan. This means there are certain income restrictions on traditional IRA deductions. For most people, this isn’t much of an issue. However, for single filers with over $77,000 in adjusted gross income ($123,000 for married couples filing jointly), there is a phase-out period. After $87,000 ($143,000 for married), the traditional IRA contribution is not deductible (also known as a non-deductible IRA).
- Extensions on IRA contributions. Active-duty members on deployment to a combat zone are allowed an extension to contribute to an IRA. This extension makes the deadline for IRA contributions fall on the same date as your respective tax return due date. IRS Publication 3 contains specific examples to help illustrate how this might play out in your tax situation.
As you transition, these rules change, so it’s important to know how those changes apply. If your income has made you previously ineligible to deduct IRA contributions, you should reevaluate once you’re in your post-military job. If your due date falls on a weekend or legal holiday, the due date is moved to the next business day. For most filers, this remains April 15, 2024. For residents of Maine or Massachusetts, the due date is April 17, 2024.
Conclusion
Transitioning military personnel and their families face significant impacts to their tax situation. Although this article covered nine of the most significant impacts, you should fully arm yourself with as much information as possible. Doing this will put you in a better position to address financial issues as they come up.
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