CHAPTER 35
Members of the Armed Forces

Special tax benefits are provided to Armed Forces personnel. A major tax-free benefit is the combat pay exclusion. Under this exclusion, members of the Armed Forces, including active duty reservists, may exclude from gross income all compensation for active service received for any month in which they served in a combat zone or were hospitalized as a result of any wound, injury, or disease incurred while serving in a combat zone. Commissioned officers are allowed an exclusion equal to the highest rate of basic pay at the top pay level for enlisted personnel, plus any hostile fire/imminent danger pay received for the month.

Other pay benefits may be tax free, and you may be able to get filing extensions and time extensions for home residence replacements. A list of tax-free benefits may be found in 35.2. Filing extensions are discussed in 35.5.

Combat zone designations apply to Iraq and neighboring areas in the “Arabian Peninsula,” Afghanistan, and the Balkans Kosovo area (35.4). From time to time, there are qualified hazardous duty areas which are treated the same as a combat zone.

35.1 Taxable Armed Forces Pay and Benefits

Armed Forces personnel report as taxable pay the following items:

Basic pay for active duty, attendance at a designated service school, back wages, drills, reserve training, and training duty.
Special pay for hazardous duty, hostile fire or imminent danger, aviation career incentives, diving duty, foreign duty (for serving outside the 48 contiguous states and the District of Columbia), medical and dental officers, nuclear-qualified officers, and special duty assignments.
Enlistment and reenlistment bonuses.
Payments for accrued leave, and personal money allowances paid to high-ranking officers.
Student loan repayment from programs such as the Department of Defense Educational Loan Repayment Program when year’s service is not attributable to a combat zone.

State income tax withholding. A state that makes a withholding agreement with the Secretary of the Treasury may subject members of the Armed Forces regularly stationed within that state to its payroll withholding provisions. National Guard members and reservists are not considered to be members of the Armed Forces for purposes of this section.

Where and when to file. If you file a paper return, mail it to the Internal Revenue Service Center for the place you are stationed. For example, you are stationed in Arizona but have a permanent home address in Missouri; you send your return to the Service Center for Arizona. For filing extensions on entering the service (35.7).

Caution

Community Property

If you are married and your domicile (permanent home to which you intend to return) is in one of the following states, your military pay is subject to community property laws of that state: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin (and Alaska for couples who opt in to make their property community property). See 1.6 for community property reporting rules.

35.2 Tax Breaks for Armed Forces Members

Military personnel and their families may qualify for numerous tax benefits. Here is a summary of some key tax breaks. For further details, see IRS Publication 3 (Armed Forces’ Tax Guide).

The following payments or allowances are not subject to tax:

Combat pay (35.4). Although qualifying combat pay is not taxed, an election may be made to treat nontaxable combat pay (35.4) as earned income for purposes of the earned income tax credit (25.8).
Living allowances for BAH (Basic Allowance for Housing). You may deduct mortgage interest and real estate taxes on your home even if you pay these expenses with BAH funds.
BAS (Basic Allowance for Subsistence) living allowances.
Housing and cost-of-living allowances abroad, whether paid by the U.S. Government or by a foreign government.
VHA (Variable Housing Allowance).
Family allowances for educational expenses for dependents, emergencies, evacuation to a place of safety, and separation.
Death allowances for burial services, death gratuity payments to eligible survivors, and travel of dependents to burial site.
Dislocation allowance, intended to partially reimburse expenses such as lease forfeitures, temporary living charges in hotels, and other expenses incurred in relocating a household.
Temporary lodging expense allowance intended to partially offset the added living expenses of temporary lodging within the United States for up to 10 days and up to 60 days abroad.
A moving-in housing allowance, intended to defray costs, such as for rental agent fees, home-security improvements, and supplemental heating equipment, associated with occupying leased space outside the United States.
Travel allowances for annual round trip for dependent students, leave between consecutive overseas tours, reassignment in a dependent-restricted status, and transportation for you or your dependents during ship overhaul or inactivation.
Defense counseling payments.
ROTC educational and subsistence allowances.
Survivor and retirement protection plan premium payments.
Uniform allowances paid to officers and uniforms furnished to enlisted personnel.
Medical or hospital treatment provided by the United States in government hospitals.
Pay forfeited on order of a court martial.
Education, training, or subsistence allowances paid under any law administered by the Department of Veterans Affairs (VA). However, deductible education costs must be reduced by the VA allowance.
Adjustments in pay to compensate for losses resulting from inflated foreign currency.
Payments to former prisoners of war from the U.S. Government in compensation for inhumane treatment suffered at the hands of an enemy government.
Benefits under Servicemembers’ Group Life Insurance.
Dividends on GI insurance. These are a tax-free return of premiums paid.
Interest on dividends left on deposit with the Department of Veterans Affairs (VA).

Caution

Withholding on Differential Wages Paid to Workers Joining Military

Employees who enlist or are called up to active military service for over 30 days may receive “differential wages” from their former employer to cover some or all of the difference between their military pay and the wages that were being received prior to joining the military. The differential wages are taxable and cannot be excluded as combat pay (35.4). Income tax must be withheld from the differential wages, but not FICA tax (Social Security and Medicare). If the active duty is for 30 days or less, differential wages are subject to FICA tax withholding as well as to income tax withholding

Distributions to reservists. Reservists called to active duty for at least 180 days are not subject to the general 10% penalty for distributions before age 59½ from retirement plans and IRAs. They also are allowed in some cases to make withdrawals of unused benefits from a health flexible spending account. These rules are discussed further at 35.8.

State and local bonuses may be tax free. Some states and municipalities pay bonuses to active or former military personnel or their dependents because of service in a combat zone. Such payments may be excludable from gross income under the combat pay rules at 35.4.

Extended statute of limitations for disability determinations. Usually, a taxpayer must file for a refund claim (47.2) within three years of the due date of the return on which the income was reported. Payments from the government based on a service-connected disability are tax free, while payments based on length of service are taxable. The Department of Veterans Affairs may take a long time to make a disability determination, with the result that taxpayers may include the payments as income. Then, when they receive a favorable determination, they can file an amended return to receive a tax refund. A law allows the refund claim to be filed until one year after the date of a disability determination to file a refund claim if this date is later than the end of the three-year period of limitation.

Death benefits. Beneficiaries who receive military death gratuities or payments from the Servicemembers’ Group Life Insurance (SGLI) program can roll these amounts over to a Roth IRA or Coverdell education savings account (ESA) within one year of receipt. The usual limits on contribution amounts and income limitations for Roth IRAs (8.21) and Coverdell ESAs (33.11) do not apply to these rollovers.

Veterans not taxed on payments from Compensated Work Therapy program. In response to a 2007 Tax Court decision that held that payments made by the U.S. Department of Veterans Affairs (VA) to disabled veterans under the Compensated Work Therapy (CWT) program are tax-free veterans’ benefits, the IRS reversed position and announced that it no longer treats CWT payments as taxable pay for services. Under the CWT program, the VA provides vocational rehabilitation services to veterans who have been unable to work and support themselves. The VA contracts with private industry and government agencies to provide these veterans with therapeutic work that emphasizes work skills training.

Disability retirement pay. Your disability retirement pay may be tax free if you are a former member of the Armed Forces of any country, the Foreign Service, the Coast Guard, the National Oceanic and Atmospheric Administration, or the Public Health Service (2.14). Tax-free treatment of disability retirement pay is retroactive to the date of the application for benefits. But Social Security disability payments made on account of a combat-related injury are taxable to the same extent as Social Security retirement payments (34.3).

35.3 Deductions for Armed Forces Personnel

For 2018 through 2025, members of the Armed Forces cannot deduct certain unreimbursed business expenses as miscellaneous itemized deductions subject to the 2% of adjusted gross income (AGI) floor because of the suspension of this deduction (19.1). Expenses subject to the suspension include:

Board and lodging costs over those paid to you by the government while on temporary duty away from your home base.
Costs of rank insignia, collar devices, gold braids, etc., and the cost of altering rank insignia when promoted or demoted.
Contributions to a “Company” fund made according to Service regulations. But personal contributions made to stimulate interest and morale in a unit are not deductible.
Court martial legal expenses in successfully defending against the charge of conduct unbecoming an officer.
Dues to professional societies.
Expense of obtaining increased retirement pay.
Subscriptions to professional journals.
Transportation, food, and lodging expenses while on official travel status. But you are taxed on mileage and per diem subsistence allowance.
Uniforms. The cost and cleaning of uniforms were deductible for years before 2018 if: (1) the uniform had to be worn on duty; (2) the uniform could not under military regulations be worn off duty; and (3) the cost exceeded any tax-free clothing allowance.

However, on Schedule 1 of Form 1040 or 1040-SR, there are two types of expenses you can deduct from gross income (no itemizing is required):

Moving expenses. If you are on active duty and move pursuant to a military order and incident to a permanent change of station, you can deduct your moving expenses; report the expenses on Form 3903 and enter the allowable amount as an adjustment to income on Schedule 1 (12.3). This includes a deduction for driving your vehicle at the 2020 rate of 17¢ per mile. You can also exclude from your income any in-kind moving and storage expenses you receive.
Reservists expenses. If you travel overnight more than 100 miles from home in connection with your performance of services as a member of the reserves, and you use your vehicle for this travel, you can deduct your mileage at the 2020 rate of 57.5 cents per mile. You can also deduct the cost of lodging and 50% of meal costs up to the regular federal per diem rate. Report the allowable travel costs on Form 2106 and enter the amount as an adjustment to income on Schedule 1 (20.1, 35.8).

35.4 Tax-Free Pay for Service in Combat Zone

If your grade is below commissioned officer (you are an enlisted member, warrant officer or commissioned warrant officer) and you serve in a designated combat zone during any part of a month, all of your qualifying military pay (see below) for that month is excluded from your taxable income. You may also exclude military pay earned during any part of a month that you are hospitalized as a result of wounds, disease, or injury incurred in a combat zone. The exclusion for military pay while hospitalized does not apply to any month that begins more than two years after the end of combat activities in that combat zone. Your hospitalization does not have to be in the combat zone.

Officers. If you are a commissioned officer, you may exclude up to the highest rate of basic pay at the highest pay grade that enlisted personnel receive per month plus any hostile fire/ imminent danger pay received for each month during any part of which you served in a combat zone or were hospitalized as a result of the combat zone service.

If you are a commissioned warrant officer, you are considered an enlisted person.

Filing Tip

Who Qualifies for Exclusion?

Members of the U.S. Armed Forces qualifying for the exclusion include commissioned officers and enlisted personnel in all regular and reserve units under control of the Secretaries of Defense, Army, Navy, and Air Force, and the Coast Guard. Members of the U.S. Merchant Marines or the American Red Cross are not included.

What is included as tax-free combat pay? The following pay received as a member of the U.S. Armed Forces qualifies for tax-free treatment: (1) active duty pay earned in any month you served in a combat zone; (2) imminent danger / hostile fire pay; (3) a reenlistment bonus if the voluntary extension or reenlistment occurs in a month you served in a combat zone; (4) pay for accrued leave earned in any month you served in a combat zone (the Department of Defense must determine that the unused leave was earned during that period); (5) pay received for duties as a member of the Armed Forces in clubs, messes, post and station theaters, and other nonappropriated fund activities. The pay must be earned in a month you served in a combat zone; (6) awards for suggestions, inventions, or scientific achievements you are entitled to because of a submission you made in a month you served in a combat zone; and (7) student loan repayments earned for military service. For each month of combat zone service during the year, 1/12 of the repayment for that year is considered tax-free combat zone pay.

Service in the combat zone includes any periods you are absent from duty because of sickness, wounds, or leave. If, as a result of serving in a combat zone, you become a prisoner of war or missing in action, you are considered to be serving in the combat zone as long as you keep that status for military pay purposes.

Retirement pay and pensions do not qualify for the combat zone exclusion. According to a Fourth Circuit Court of Appeals decision, a Navy severance pay package was taxable although the recipient became entitled to the payment while on active duty in the Persian Gulf. The court differentiated the package, which was provided in order to entice the man to leave the service, from a reenlistment bonus provided as compensation for active service.

Law Alert

IRA Contributions Based on Tax-Free Combat Pay

Members of the armed services serving in a combat zone may base contributions to either a traditional IRA (8.2) or a Roth IRA (8.21) on their tax-free combat pay.

Combat zones. A combat zone is any area the President of the United States designates by Executive Order as an area in which the U.S. Armed Forces are or have engaged in combat. An area becomes and ceases to be a combat zone on the dates designated by the President. When this book was completed, there were three designated combat zones: (1) the Afghanistan area, including countries in which military service has been certified by the Defense Department as in direct support of the operations in Afghanistan, (2) the Arabian Peninsula area, and (3) the Kosovo area. The Sinai Peninsula in Egypt is a qualified hazardous duty area that is effectively treated the same as a combat zone. IRS Publication 3 has the full list of countries in each of these areas.

Qualifying service outside a combat zone considered combat zone service. Military service outside a combat zone is considered to be performed in a combat zone if: (1) the service is designated by the Defense Department to be in direct support of military operations in the combat zone, and (2) the service qualifies you for special military pay for duty subject to hostile fire or imminent danger. Military pay received for this service will qualify for the combat zone exclusion if the other requirements are met.

Nonqualifying service. The following military service does not qualify as service in a combat zone: (1) presence in a combat zone while on leave from a duty station located outside the combat zone; (2) passage over or through a combat zone during a trip between two points that are outside a combat zone; and (3) presence in a combat zone solely for your personal convenience. Such service will not qualify you for the pay exclusion.

Hospitalized while serving in a combat zone or after leaving a combat zone. If you are hospitalized while serving in a combat zone, the wound, disease, or injury that is the reason for the hospitalization will be presumed to have been incurred while serving in the combat zone unless there is clear evidence to the contrary. The presumption may also apply if you were hospitalized after leaving a combat zone.

Form W-2. The wages shown in Box 1 of your Form W-2 should not include combat pay. Retirement pay is not combat pay.

35.5 Tax Deadlines Extended for Combat Zone or Contingency Operation Service

You are allowed an extension of at least 180 days (see below) to take care of tax matters if you are a member of the Armed Forces who served in a combat zone or in a contingency operation. The extension applies to filing tax returns, paying taxes, filing a Tax Court petition, filing refund claims, and making an IRA contribution. The time allowed for the IRS to begin an audit or take collection actions is also extended. See IRS Publication 3 for details on the extension rules.

Filing Tip

Spouses of Combat Zone Personnel

If your spouse serves in a combat zone or contingency operation, you are generally entitled to the same deadline extension as he or she is. However, any extra extension for your spouse’s hospitalization within the United States is not available to you. Further, a spouse’s extension does not apply to any year beginning more than two years after the area ceases to be a combat zone or the operation ceases to be a contingency operation.

Support personnel. The deadline extension also applies if you are serving in a combat zone or contingency operation in support of the Armed Forces. This includes Red Cross personnel, accredited correspondents, and civilian personnel acting under the direction of the Armed Forces in support of those forces.

Extension is a minimum of 180 days. Your deadline for taking actions with the IRS is extended for at least 180 days after the later of: (1) the last day you are in a combat zone or serving in a contingency operation (or the last day the area qualifies as a combat zone or the operation qualifies as a contingency operation), or (2) the last day of any continuous qualified hospitalization for injury from service in the combat zone or contingency operation. Hospitalization may be outside the United States, or up to five years of hospitalization in the United States.

Time in a missing status (missing in action or prisoner of war) counts as time in a combat zone or contingency operation.

In addition to the 180 days, a filing deadline is also extended by the number of days you had left to file with the IRS when you entered a combat zone or began serving in a contingency operation. If you entered the combat zone or began contingency operation service before the time to file began, the deadline is extended by the entire filing time.

35.6 Tax Forgiveness for Combat Zone or Terrorist or Military Action Deaths

If a member of the Armed Forces is killed in a combat zone or dies from wounds or disease incurred while actively serving in a combat zone, any income tax liability for the year of death and any earlier year in which he or she actively served in a combat zone is waived. In addition, the service member’s estate is entitled to a refund for income tax paid while serving there.

If a member of the Armed Forces was a resident of a community property state and his or her spouse reported half of the military pay on a separate return, the spouse may get a refund of taxes paid on his or her share of the combat zone pay.

Forgiveness benefits apply to an Armed Forces member serving outside the zone if service: (1) was in direct support of military operations there, and (2) qualified the member for special military pay for duty subject to hostile fire or imminent danger.

Missing status. The date of death for a member of the Armed Forces who was in a missing status (missing in action or prisoner of war) is the date his or her name is removed from missing status for military pay purposes. This is true even if death occurred earlier.

Tax forgiveness for civilian or military personnel killed in terroristic or military action. Tax liability is waived for civilian or military U.S. government employees killed in terroristic or military actions, even if the President has not designated the area as a combat zone. The individual must be a U.S. government employee both on the date of injury and date of death. Tax liability is waived for the period beginning with the taxable year before the year in which the injuries were incurred and ending with the year of death. Refund claims for prior years must generally be filed on Form 1040-X by the later of three years from the time the original return was filed or two years from the time the tax was paid. However, if death occurred in a combat zone, the filing period is extended by the time served in the combat zone, plus the period of continuous hospitalization outside the U.S., plus an additional 180 days.

Caution

Training Exercises

Tax forgiveness for personnel killed in a “military action” does not apply to a U.S. civilian or military employee who dies as a result of a training exercise.

How tax forgiveness is claimed. If the individual died in a combat zone or in a terroristic or military action, you file as the individual’s representative: (1) Form 1040 or 1040-SR if a U.S. individual income tax return has not been filed for the tax year. Form W-2, Wage and Tax Statement, must accompany the return. (2) Form 1040-X if a U.S. individual income tax return has been filed. A separate Form 1040-X must be filed for each year in question. See IRS Publication 3 for how to identify the military or terrorist action in which the death occurred.

An attachment should accompany any return or claim and should include a computation of the decedent’s tax liability before any amount is forgiven and the amount that is to be forgiven.

The following documents must also accompany all returns and claims for refund: (1) Form 1310, “Statement of Person Claiming Refund Due a Deceased Taxpayer”; and (2) a certification from the Department of Defense. Department of State certification is required if the decedent was a civilian employee of an agency other than the Department of Defense. See IRS Publication 3 for the IRS address where the tax forgiveness claim and documents must be filed.

35.7 Extension To Pay Your Tax When Entering the Service

If you are unable to pay your income taxes when you enter the Armed Forces (whether they became due before or during your military service), you may get an extension until 180 days after leaving the military to pay the tax, provided that you apply for the extension after receiving a notice from the IRS asking for payment. Your request must show that your ability to pay has been materially affected because of your military service. If the request is granted and you pay the entire tax due by the end of the postponement period, no interest or penalties will be charged for that period.

The extension does not cover your spouse, who must file a separate return and pay the tax due. But you and your spouse may file a joint return before the postponement period expires even though your spouse filed a separate return for that particular year.

Automatic extension of time to file your return. If you are on duty outside the U.S. or Puerto Rico on April 15, 2021, you get an automatic two-month extension to file your 2020 return; see page 6.

Interest charged on back taxes. If you do not show hardship qualifying you for the above interest-free payment extension, the maximum interest rate the IRS may charge while you are on active duty for taxes incurred prior to your entry into active service is 6%, provided your service affected your ability to pay. Since 6% is the maximum interest rate, this rule does not provide a benefit when the regular interest rate is lower, and rates have not exceeded 6% in recent years (46.8).

35.8 Tax Information for Reservists

Due to the suspension of miscellaneous itemized deductions subject to the 2% of adjusted gross income (AGI) floor from 2018 through 2025, no deduction is allowed for reserves-related travel costs unless you travel overnight more than 100 miles away from your tax home to a meeting or training camp.

If you travel overnight more than 100 miles away from your tax home (20.6) to a reservist meeting or training camp, report the related travel expenses on Form 2106 and enter the allowable amount on Line 11 of Schedule 1 (Form 1040 or 1040-SR) as an adjustment to income (above-the-line deduction). You can deduct your lodging costs, 50% of meal costs and incidental expenses provided they do not exceed the regular federal per diem rate (20.19), and if you use your vehicle for this travel, you may claim the IRS’ standard mileage rate (57.5 cents per mile for 2020) plus any parking fees, tolls, or ferry fees.

Deferring tax payments and reduction of IRS interest rate. If you owed a tax deficiency to the IRS before being called to active duty, the IRS may defer payment, without interest, if your ability to pay has been severely impaired by your call-up (35.7).

Penalty-free withdrawal and repayment of qualified reservist retirement distribution. If you are called to active military duty for over 179 days or indefinitely, and during the active duty period you receive a distribution from a traditional IRA or a distribution attributable to elective deferrals (from a 401(k) or 403(b) plan), the distribution is considered a qualified reservist distribution. If you are under age 59½ when you receive a qualified reservist distribution, you are not subject to the 10% penalty for early distributions (7.13, 8.12).

Furthermore, you can recontribute a qualified reservist distribution to a traditional IRA within two years after the end of the active duty period. Repayment must be made to a traditional IRA even if the distribution was from a 401(k) or 403(b) plan. The repayment should be reported on Form 8606 (Line 1) as a nondeductible contribution to the traditional IRA.

Distributions of unused balance from health flexible spending arrangement (HFSA). If you contribute to a health flexible spending arrangement (3.16), but before you can use up your HFSA balance to reimburse your medical expenses you are called to active military duty for over 179 days, or indefinitely, you can withdraw the funds and use them for any purpose if your employer allows “qualified reservist distributions” and you withdraw the balance by the regular plan deadline for receiving reimbursements. If your employer allows employees to obtain reimbursements of medical expenses within a 2½-month grace period after the end of the plan year (3.16), you have the same deadline to receive a distribution of your HFSA balance, but it does not have to be used to pay medical expenses.