Understanding DoD Retirement Tax Implications
Understanding DoD Retirement Tax Implications
Military retirement taxes have gotten complicated with all the state exemptions, withholding rules, and benefit interactions flying around. As someone who’s filed taxes as a military retiree for years and helped fellow vets avoid costly mistakes, I learned everything there is to know about minimizing your tax burden in retirement. Today, I will share it all with you.
Taxable Retirement Income
Probably should have led with this section, honestly. Your military retirement pay is federally taxable as ordinary income—same as if you were still earning a paycheck. The good news? It’s not subject to FICA taxes (Social Security and Medicare), so you’re not losing 7.65% off the top like you did on active duty. Your tax liability depends on your total income and tax bracket, so if you’re working a second career or have investment income on top of your pension, you could be paying significant taxes.
State Tax Considerations
Here’s where you can really save money: picking the right state to retire in. State tax treatment of military pensions varies wildly. States like Florida, Texas, Washington, Nevada, Tennessee, and a few others have no state income tax at all—your pension is completely tax-free. Others like Alabama, Illinois, Hawaii, and Mississippi fully exempt military retirement pay from state taxes even though they tax other income. Then you’ve got states like California, Vermont, and Rhode Island that tax your pension just like any other income.
- States with full exemption: Alabama, Illinois, Hawaii, Kansas, Mississippi, and more
- States with partial exemption: Arizona, North Dakota, Oregon, and others
- States that fully tax military retirement pay: California, Vermont, Montana, and others
Moving from California (13.3% top tax rate) to Florida (0% tax) can effectively give you a 10% raise on your pension without changing anything else. That’s what makes state tax planning endearing to us retirees—it’s one of the few things you have complete control over.
Survivor Benefit Plan (SBP)
SBP premiums are deducted from your gross retirement pay before taxes, which reduces your taxable income. If your pension is $3,000/month and SBP costs $195, you only pay taxes on $2,805. When your survivor receives SBP payments after you die, those payments are taxable income to them. So SBP gives you a tax break now but creates a tax liability for your survivor later.
Disability Benefits
VA disability compensation is completely tax-free, both federally and in every state. This is huge if you’re receiving both military retirement pay and VA disability. Under CRDP (Concurrent Retirement and Disability Pay), you can receive both without offset if you’re rated 50% or higher. The portion that’s VA disability remains tax-free, while the DoD retirement portion is still taxable. Combat-Related Special Compensation (CRSC) is also tax-free.
Thrift Savings Plan (TSP) Withdrawals
TSP withdrawals follow the same tax rules as civilian 401(k)s. Traditional TSP withdrawals are taxed as ordinary income when you take them out. Roth TSP withdrawals are tax-free if you’re 59½ or older and the account has been open at least 5 years. If you withdraw before 59½, you’ll pay income tax plus a 10% early withdrawal penalty unless you qualify for an exception.
- Traditional TSP: Pay taxes on withdrawal
- Roth TSP: Tax-free if conditions met
- Early withdrawals (under 59½): 10% penalty plus income tax
Strategic withdrawal planning can minimize your tax hit. For example, taking withdrawals in years when your other income is low keeps you in a lower tax bracket.
Tax Withholding and Estimated Taxes
DFAS withholds federal income tax from your retirement pay based on what you tell them via Form W-4P. If you don’t withhold enough, you’ll owe money (plus penalties and interest) when you file your return. If you withhold too much, you’re giving the government an interest-free loan. Review your withholding annually, especially if your situation changes—second career income, spouse’s income, investment gains, or major deductions.
Deductions You’re Probably Missing
Here’s where retirees leave money on the table. If you’re working a second career and contributing to a 401(k) or IRA, those contributions are tax-deductible (traditional) or grow tax-free (Roth). If you itemize deductions, you can deduct mortgage interest, property taxes, charitable donations, and medical expenses exceeding 7.5% of your AGI. Moving expenses for a new job used to be deductible but aren’t anymore under current tax law. State and local tax (SALT) deductions are capped at $10,000.
