Tax Breaks for Active Military Personnel and Reservists

February 9, 2009 by: The Tax Man

More than three million individuals are either on active or reserve duty with the U.S. armed forces. Just before Memorial Day, Congress gave these individuals and their families some important tax relief in the Heroes Earnings Assistance and Relief Tax Act of 2008. The tax incentives are targeted to military personnel on active duty, reservists called to active duty and military families.

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Combat pay.
Combat pay is tax-free. However, this tax-free treatment can cause some military families to loose eligibility for the earned income credit. The military tax relief act treats combat pay as earned income for purposes of the earned income credit. This treatment is permanent and is also retroactive December 31, 2007.

Veterans bonuses.
When a serviceman or woman returns home from combat, some states pay them a “bonus” for their military service. The IRS has traditionally treated these bonuses as nontaxable gifts. Now, Congress has made this treatment the law. If your state pays a veterans bonus, the bonus is tax-free for federal income tax purposes.

Retirement savings.
The new law also relaxes some of the tough rules for withdrawing funds from a 401(k) or similar arrangement for reservists called to active duty. Reservists called to active duty for at least 179 days can take money out of a 401(k) or similar plan without paying a penalty. The reservist generally has two years after the end of the active duty period to repay (in one or more contributions) the amount of the distribution.

Reservist’s retirement plans
The military tax relief act also makes it easier for employers to contribute to a reservist’s retirement plans while he or she is on active duty. The new law treats differential pay, which the pay that some employers provide to reservists to make up the difference between their military pay and their regular pay, as wages for withholding, IRA contributions and some retirement plans. Small employers also benefit from a new tax credit if they offer differential pay.

Disability claims.
The U.S. Department of Veterans Affairs receives thousands of disability claims every year and has a huge backlog of unprocessed claims. The wait can have unforeseen tax consequences. A VA disability award makes a portion of previously-taxed military retirement pay tax-free. Disabled veterans have to file amended tax returns to claim refunds. Often, the statute of limitations for claiming a refund has passed. The new law gives disabled veterans more time to claim these refunds.

Military Death benefits.
Military death and insurance benefits are very generous and beneficiaries need to carefully invest the proceeds. The new law gives beneficiaries of military death and insurance benefits more choices about where to invest these proceeds. Survivors can contribute all or part of the proceeds into a Roth IRA without having to worry about income and contribution limits. The same treatment is available for Coverdell Education Savings Accounts. At the same time, the new law also enhances the benefits that survivors receive under some employer-provided plans.