Military retirement pay usually is taxable, but not always. If your pay is based on a combat-related disability, for instance, some or all of it may be tax-free. The good news is that you'll rarely have to guess how to declare it on your tax return -- the military generally makes it very clear what side of the tax line your retirement pay falls.
The U.S. Army puts it in simple terms -- if your retirement pay is based on your age or the length of time you served, you pay income tax on it. These funds are considered the same as regular income for IRS purposes, and therefore taxed accordingly. However you're off the hook for Social Security and Medicare taxes on retirement pay.
If your retirement pay is calculated based on a combat-related disability, it isn't taxable. Pay based on a non-combat disability also is exempt if you served before Sept. 24, 1975. The military doesn't leave it up to you to determine which category your funds belong to. When you retire, you'll receive a letter from the Defense Finance and Accounting Service telling you whether your pay is based on disability, age or the number of years you served.
If you receive compensation for a disability from the Department of Veterans Affairs, that money is tax-exempt. If you're on the temporary or permanent disability retirement list but not receiving VA compensation, you can exempt some of your regular retirement pay. Take your military disability percentage — the degree to which you're disabled — and multiply it by your active duty pay at time of retirement. You can exempt that much of your retirement pay from taxes.
Don't worry about crunching the numbers yourself: DFAS will do it and provide the information on your 1099-R, the equivalent of a W-2 for retirement pay.
If you receive some VA disability compensation but the multiplication formula gives you a bigger exemption, you can use the bigger figure.
Where You Live
Your choice of retirement home can affect whether your income is taxable at the state level. Some states, such as Florida, don't charge any income tax at all. Some of those that do include an exemption for some or all of military retirement pay. For example, Maryland at time of this publication exempts the first $5,000 of military pay from state tax. Iowa offers a complete exemption. The exact list is constantly changing, as states make new cuts to attract military retirees.