Tax Exclusion Rules for Service-Connected Military and Government Pensions

This guide explains when MILITARY AND GOVERNMENT DISABILITY PENSIONS are tax-free at the federal level, who qualifies, what proof you need, and how to apply or fix past returns. It covers the armed forces, plus other listed services with similar protections.

Who Qualifies for Tax-Free Disability Payments

You can exclude payments from income if they are a pension, annuity, or similar allowance paid for injury or sickness from active service in:

• The armed forces of any country
• The National Oceanic and Atmospheric Administration (NOAA)
• The Public Health Service (PHS)
• The Foreign Service

This exclusion applies only when the payment is for a SERVICE-CONNECTED DISABILITY (an illness or injury tied to your service) and one of the conditions below is met.

Eligibility Rules (with Examples)

Your disability payments are not included in federal income if any of these apply:

1. You were entitled to receive a disability payment before September 25, 1975.
   • Example: A Navy retiree approved for disability pay in 1974 continues to exclude it today.
2. You were a member (or had a binding written commitment to join) one of the listed services or its reserve on September 24, 1975.
   • Example: A PHS officer with a signed entry contract dated September 24, 1975 qualifies.
3. Your disability is combat-related, meaning it:
   • Results directly from armed conflict,
   • Happens during extra-hazardous service,
   • Occurs under conditions simulating war (such as field maneuvers), or
   • Is caused by an instrumentality of war.
   • Example: A Soldier injured by a training explosion during war exercises can exclude qualifying disability pay.
4. You would be entitled to VA disability compensation if you applied. The excluded amount equals what the VA would pay you, even if you haven’t filed yet.
   • Example: A Marine not yet rated by VA can still exclude the portion equal to the VA amount once entitlement is clear.

Important special rules:
– Pensions based only on years of service (or age) are taxable, except for the portion tied to a service-connected disability. The disability percentage is excluded; the remaining retired pay is taxable.
– VA disability compensation and VA pension are fully tax-free.
– Combat-Related Special Compensation (CRSC) is tax-free; you must apply through your branch.
– Concurrent Retirement and Disability Pay (CRDP) is generally taxable, as it restores retired pay.

According to analysis by VisaVerge.com, many Veterans miss refunds when a later VA decision retroactively changes the taxable portion of their retired pay.

Required Documents and Proof

Gather records that show both your service and the link between your disability and service:

• Military, NOAA, PHS, or Foreign Service records showing active duty and the nature of duty (e.g., hazardous duty orders, training records)
• Medical records and line-of-duty findings tying the injury or illness to service
• VA rating decision or award letter (if available)
• DFAS Retiree Account Statement (RAS) showing retired pay and any disability portion
• CRSC approval letter (if applicable)
• Written commitment dated September 24, 1975, if you rely on the 1975 rule
• Any correspondence showing entitlement to disability pay before September 25, 1975

Forms you may need:
– VA Form 21-526EZ (Application for Disability Compensation and Related Compensation Benefits): https://www.va.gov/find-forms/about-form-21-526ez/
– Form 1040-X (Amended U.S. Individual Income Tax Return) for refund claims after a retroactive VA decision: https://www.irs.gov/forms-pubs/about-form-1040-x

How to Apply or Claim the Exclusion

Follow these steps to set up the correct tax treatment and recover any past overpayments:

1. Confirm service-connection.
   • If you don’t have a VA rating yet, file VA Form 21-526EZ. A VA decision helps set the non-taxable amount.
2. Check if a combat-related finding is possible.
   • If your injury is combat-related, apply for CRSC through your branch to receive tax-free compensation (separate from VA pay).
3. Review your retired pay.
   • The part tied to your disability percentage is excluded. The rest, based on years of service, is taxable. DFAS guidance (2024 update) explains this split on retired pay statements.
4. File your tax return correctly.
   • Do not include VA disability compensation in income.
   • Exclude the disability portion of retired pay.
   • Include only the taxable remainder.
5. If you get a retroactive VA rating, amend past returns.
   • Use Form 1040-X to claim a refund for years where you paid tax on amounts that are now excluded.
   • Recent IRS guidance allows an extra year beyond the usual three years, if the tax years fall within five years of the VA decision date.
6. Keep detailed records.
   • Save all letters showing disability percentage, combat-related status (if any), and DFAS statements.

Practical Tips to Meet the Rules

• Put dates front and center. September 24–25, 1975 triggers special protection. Keep any proof from that time.
• If you qualify for VA pay but haven’t applied, the law still lets you exclude an amount equal to the VA benefit. Filing with VA helps you document it cleanly.
• CRSC is powerful for combat-related disabilities because it’s tax-free. Ask your branch about needed evidence (incident reports, award citations, training orders).
• For retirees with both VA and military retired pay, remember: CRDP is taxable, CRSC is not.
• Some states don’t tax military retired pay at all, and many give extra relief for disability portions. Check your state rules.
• Spouses and survivors should review Survivor Benefit Plan (SBP) premiums; SBP contributions reduce taxable income.

Special Notes for NOAA, PHS, and Foreign Service

The same federal tax exclusion rules apply to disability payments tied to service in NOAA, PHS, and the Foreign Service, including the 1975 dates and combat-related standards (where relevant). Keep service orders, medical evidence, and any special duty records that show hazardous or war-like conditions.

Where to Find the Official Rule

The Internal Revenue Service explains these exclusions in Publication 525. See the official IRS guide here: https://www.irs.gov/publications/p525

Common Scenarios, Clearly Explained

• Years-of-service retiree later gets a VA rating: The disability portion becomes non-taxable. File Form 1040-X for any open years to claim refunds.
• 100% VA disability rating with separate retired pay: VA compensation stays tax-free; retired pay is taxable unless covered by CRSC or excluded by the disability portion rule.
• Training injury during war games: If conditions simulate war, that can meet the combat-related standard; collect training orders and incident reports.

Compliance Checklist

• Do you have proof of service and, if used, a pre-September 25, 1975 entitlement or September 24, 1975 commitment?
• Do you have a VA rating or clear entitlement to VA compensation?
• Have you split retired pay into disability (excluded) and years-of-service (taxable) amounts?
• If a VA decision was retroactive, did you file Form 1040-X within the allowed time?
• For combat-related cases, did you apply for CRSC?

For many families, getting this right means larger refunds and lower taxes going forward. If you’re unsure, speak with a tax professional who works with Veterans’ benefits and DFAS statements.