Income Taxes After Military Retirement: Don’t Get Stuck With A Huge Bill

There’s a rumor floating around that somehow your taxes are going to zoom up after you retire from the military. As with many rumors, there is a bit of truth in it, but there’s also just a lot of confusion. It is true that some military families end up with large tax bills in their first year or two after retirement, but there is no magic change in the way your taxes are calculated. There may, however, be big changes in your income, and it is important to ensure that you’re accounting for those changes in your tax planning.

Withholding

The key to understanding and fixing this potential problem is to understand income tax withholding. Withholding is our country’s system of paying towards your income taxes as you earn the money, rather than waiting until the end of the year to come up with a lump sum. However, our withholding system is imperfect: first, because it depends on the employee giving the right withholding instructions, and second, because it can have difficulty calculating accurately if your income varies across the year. The new IRS Form W-4, Employee’s Withholding Certificate, is a big step in solving both those problems, but it still requires the employee to give the right instructions.

You probably set up your withholding using a paper W-4 form when you started a new job, but you can always change your withholding. Many employers, including the Department of Defense, put that option in their online payroll portal. It’s usually pretty simple to change withholding as necessary, and should take effect within a month or so.

Military Retirement Pay

Military retirement pay is subject to federal income taxes just like any other ordinary income. States treat military retirement pay differently – some states tax military retirement pay, some states don’t tax military retirement pay, and some states tax a portion of it.

Two things to note about military retirement pay: You don’t pay payroll taxes (Social Security and Medicare), and Survivor Benefit Plan premiums are taken out pre-tax, lowering your taxable income now.

You can set your income tax withholding for your military retirement pay through myPay. You need to make sure that you have accounted for all your income when you set up your withholding for your military retirement pay – that includes a new job, spouse employment, any other sources of income.

In many cases, you’ll need to set up state withholding for the first time, or to reflect your new, post-retirement state of legal residence.

About Non-Taxable Allowances

I often hear people say that you’ll pay more taxes after retirement because you aren’t getting non-taxable allowances such as Basic Allowance for Housing and Basic Allowance for Subsistence. Once again, that’s sort of true, and it’s also completely not true.

You’re not paying more taxes on any other income because you are no longer receiving non-taxable allowances.

But, if you are making the same total income as you were when receiving taxable allowances, it’ll all be taxed, so you’ll be paying more taxes than if the same amount of income included non-taxable allowances.

On one hand, this is sort of a potato-pahtahto sort of thing. On the other hand, saying that you’ll pay more taxes because you aren’t receiving non-taxable allowances isn’t really accurate.

New Job Income

If you start another job after military retirement, make sure that you include your military retirement pay, spouse’s income, and any other sources of taxable income when you set up your withholding for that new job. Otherwise, they’ll only withhold the right amount of taxes as if that job is your only income, and you’ll come up short.

While I don’t have data to prove this, this is the number one reason that I see that people end up with large tax bills their first years of retirement: not withholding enough from their new job’s pay.

Spouse Income

If your spouse works, then you need to factor that income into the entire picture. All sources of income should set their withholding to reflect all of the income that’s coming into the tax unit. Same concept as above.

Other Income

If you have other taxable income, you need to either submit quarterly estimated tax payments, or increase your withholding somewhere else. For many military families, this might be rental property income, or a small business.

VA disability benefits are NOT taxable, so you don’t have taxes withheld from those payments, and you don’t need to include that income in your overall withholding calculations.

State Taxes

Many active duty military families maintain their state of legal residence in a state that does not have state income taxes. If you settled after retirement in a state that has income taxes, it can be a little shock! And you have to inform the Defense Finance and Accounting Service that you’ve changed your state of legal residence, so they can withhold the appropriate state taxes out of your military retirement pay.

This isn’t rocket science, but it isn’t obvious if you’re not a geek, like me, who thinks about these things all the time. Fortunately, the solution is pretty simple: ensure that you have the right withholding instructions with all sources of income. If you’re not sure that you’re doing it right, your civilian job’s human resources office may be able to help, or it might be worth an hour’s consultation with a tax professional who understands military retirement. Or even ask a tax-smart friend! Whatever you do, don’t just figure that you’ll wait until April to deal with it. Because a huge tax bill is no fun.