IRS Denies Military Retirement “Net Disability Exclusion”

One of the book’s contributors alerted me to this problem. Some military retirees (or their tax preparers) are incorrectly applying the net disability exclusion to their pensions. This error has floated around the Internet since at least 1999 and it’s already introduced a number of veterans to their friendly IRS tax auditors.

Here’s a typical pitch from one of the websites helping to “spread the word” about the net disability exclusion:

The Veteran’s Tax Package, if you qualify, is a calculation that allows the taxpayer to receive an additional tax refund on amended returns with both the Internal Revenue and state taxing authorities. If you have a disability rating that has been confirmed by letter from the Veteran’s Administration and/or receive retired military pay from any branch in the military and pay taxes each year due to a high tax liability you more than likely qualify. This process is known as the Net Disability Exclusion per the Internal Revenue Code 1.122-1.

Note that tricky “if you qualify” disclaimer.

There’s also an official-looking PDF being spread by e-mail, with “instructions” on how to “calculate” the exclusion:


The QUALIFICATIONS – (1) receiving retired pay from one of the military services based on either length of service and/or medical disability: (2) waiving part of one’s retirement pay in order to receive VA disability for a service-connected disability; and/or) waiving/withholding additional retirement pay to pay for Survival Benefit Plan premiums. FYI – The ability to amend based on this regulation ceases for the tax year that the retiree becomes 65, but you can still file for those years up to your 65th birthday.


THE COMPUTATION – Take your taxable retired income per the 1099R (for the tax year involved), and the amount of retired pay you waived in order to receive VA compensation for a service-connected disability, and then add any amounts that were withheld for SBP payments. The sum of this computation is your gross retired pay (GRP) for that year. Then divide your GRP by the percent of active duty pay (# of years of Title 10 Service times 2.5%) you are entitled to receive as “retired pay.” This computation provides your Adjusted GRP (AGRP) . Next, multiply your AGRP by your percent of VA disability – this provides the amount that should be excluded as disability retired pay (IAW Treasury Reg 1.122-1(d)); then subtract the amount of retired pay actually waived to receive VA disability compensation. The result of this computation is the “Net Disability Exclusion” (NDE) to be entered on Line 1, Column B of your Form 1040X. Now compute the amount of tax owed by referring to the tax tables for the applicable year. Be sure to provide a statement explaining the basis for all your computations (e.g., years of service, VA disability percentage, etc., and cite Treasury Reg 1.122-1(d)).

I’ve been doing my own taxes for over 30 years, and I thought I was pretty good at researching the IRS regulations. I’d never heard of this exclusion before, but I’m not receiving disability benefits and I’m not intimately familiar with VA programs. I thought this was something that had grown out of the wars or other recent changes to veteran’s benefits. Heck, the exclusion’s being promoted with websites and e-mails and PDFs of sample tax returns. Looks like a great deal!

I can completely understand how thousands of military retirees would claim this exclusion. However, most of them would be wrong.

Unfortunately, the vast majority of military retirees are not eligible for the net disability exclusion. This urban legend is based on an incorrect interpretation of a regulation that handles a completely different issue: military retirements due to medical disability rendering the servicemember unfit for duty. That’s different from a retirement based on years of service, even if the military retiree is receiving VA compensation for a service-connected disability.

Some veterans have been (erroneously) claiming this exclusion for several years, which led others to believe that the IRS agrees with the exclusion. It gives this urban legend an extra sheen of credibility, but the reality is that the IRS computers and agents didn’t notice the problem until it became widespread. After inquiries by experienced tax preparers and CPAs, the IRS is now flagging this exclusion. Veterans who have been incorrectly taking the exclusion (some for years) are currently facing audits, back taxes, interest, and penalties.

Let me say that again: the “net disability exclusion” only applies to servicemembers who have been retired for medical disability (unfit for duty), not those who retired for eligibility by years of service.

WARNING: Long tax discussion follows. Read it only if you want to. If you understand that you’re probably not eligible to take the net disability exclusion, then you can stop reading here. If your tax accountant tries to use the net disability exclusion, please refer them to the following text.

DISCLAIMER: I used to read nuclear reactor plant manuals for a living, and I’m a tax geek, but I’m not a CPA. The following section includes links to CPA interpretations of the tax code along with an IRS letter that clarifies the net disability exclusion. If your tax accountant is trying to claim the net disability exclusion then they need to understand these references and your type of military retirement.

I find it very difficult to read the official Income Tax Regulations on the U.S. Government Printing Office website, but here’s a quote from a more user-friendly format of 1.122-1(d):

(d) Examples with respect to the Retired Serviceman’s Family Protection Plan. The rules discussed in this section relating to the Retired Serviceman’s Family Protection Plan (10 U.S.C. 1431) may be illustrated by the following examples:

Hmm. I suspect that some of you younger readers are wondering what the heck a “Retired Serviceman’s Family Protection Plan” is.

It turns out that this tax regulation promulgates rules for reducing the taxable amount of military retired pay when receiving disability benefits and when paying for survivor benefits insurance. The RSFPP is a predecessor of today’s Survivor Benefits Program, and the regulation allowed military retirees to exclude the premiums paid for those programs from their taxable income. This situation occurred around 1966, over 50 years ago.

The first three examples of 1.122-1(d) contain scenarios for figuring out how much income could be excluded for paying RSFPP or SBP premiums. This is the regulation that allows military retirees to exclude these premiums from their taxable income, but today the Defense Finance and Accounting Service already takes care of that exclusion on the retiree 1099-R tax form. Another discussion of this situation is in this January 2012 article of the Enrolled Agent Journal.

A separate situation of those first three examples applies when a servicemember retires from the military and files a disability claim with the VA. As thousands of veterans are all too keenly aware, VA determination of a claim can take more than two years before awarding compensation retroactive to the date of eligibility. The problem is that a military retiree has already paid taxes on that portion of their pension which has now been replaced by tax-free VA compensation.

In that situation, military retirees file amended tax returns for the earlier years in which their VA compensation was retroactively awarded. The amendment reduces their retired pay by the amount of the compensation, which reduces their taxable income and entitles them to a refund of the taxes they paid. For the current tax year (where DFAS has already paid some pension that would be incorrectly taxed) the retiree reduces the amount of their retired pay by the VA compensation and includes a copy of the VA disability award letter. In future tax years, the DFAS 1099-R will report the correct amount of retired pay which has been reduced by VA disability compensation. This was a one-time correction, and no further exclusions are made. More details are explained in this article by Tom Philpott, including guidance from MOAA’s Steve Strobridge.

However, the next three examples of 1.122-1(d) cover a different scenario: military retirement because of disability (unfit for duty) rather than eligibility by years of service. In this situation (which applies to very few military retirees) a veteran’s retired pay can be calculated by either percentage of disability or by years of service. Some of this pay can be excluded under Tax Regulations 104(a)(4) and 105(d) permitted by Title 10 Section 1403 of the U.S. Code.

In other words, these IRS regulations cover disability retirements when the servicemember is unfit for duty. That’s what the IRS means by “net disability exclusion”. Examples (4)-(6) do not apply to military retirees who retired under eligibility by years of service and have waived a portion of their retirement pay to receive the VA’s disability compensation. They only apply to military disability retirements.

However, the last three examples of 1.122-1(d) just mention sections 104(a)(4) and 105(d) of the tax regulations without any further explanation. It’s easy to overlook those caveats and to only focus on the bottom line that allows a big fat net disability exclusion. As the improper use of this exclusion began to spread, at least one CPA pointed out that many net disability exclusions were based on an incorrect interpretation of a memorandum issued by the IRS Chief Counsel in 1999. The IRS letter was promulgated after a query for assistance was submitted to clarify the issue.

The question submitted to the IRS was:

… a taxpayer retired from the armed forces and receives military retired pay based on years of service from the Department of Defense (DOD). The taxpayer was not retired for disability but subsequently applied to the Veterans Administration (VA) for disability benefits under Title 38 of the U.S. Code. The VA determined that the taxpayer had a 10% disability and he elected to waive his DOD years of service retirement benefits to the extent of his VA benefits so that he could receive the VA benefits tax free. The taxpayer also elected to reduce his DOD retirement under the Survivor Benefit Plan.

The IRS letter clarifies the net disability exclusion:

… the taxpayer in the instant case was retired for years of service, not for disability. No part of his retired pay was “received for personal injury or sickness” as required under section 104(a)(4)1.

… Unlike the taxpayer in Example (4) [of Treasury Reg 1.122-1(d)], however, his gross retired pay should not be further reduced under section 104(a)(4) because it was not “received for personal injury or sickness,” a prerequisite to that exclusion. Moreover, to the extent sections 104(b)(2)(D) and 104(b)(4) may create an exception for amounts previously received as service retirement (which correspond to the VA disability payments), the exception would not be applicable in this case because the taxpayer filed a waiver equal to the amount of his VA compensation. Because the taxpayer has already reduced his taxable retired pay by the amount of the VA benefits, he should not be entitled to a second exclusion of 10% of his base pay under section 104(a)(4) on account of the same VA disability determination.

So what happens if you improperly claim the net disability exclusion? Here’s what the IRS and the state of California are doing to one retiree:

My 2005 thru 2010 net disability exclusion (NDE) requests were previously approved and refunds awarded. But now the IRS has determined they want over $15,000 … returned to them. Not only this, because most states accept/enforce IRS policy, my state (CA) now wants back $5000 based on IRS NDE denial.

If you’ve taken the net disability exclusion in the past and you now realize that you aren’t eligible, then you’re already subject to paying those back taxes. The IRS will eventually catch up to you and expect you to pay all those years of accumulated penalties and interest. If you delay correcting the mistake then you’ll only end up paying more money. Seek professional help from a tax preparer or CPA who’s familiar with military retirements and disability compensation. Take them through this post and its links, and then file amended returns for all of the years in which you improperly took the exclusion.

Don’t get suckered by this military version of an urban legend. The “net disability exclusion” does not apply to most military retirees, even if they were told by tax professionals that it seems legitimate.

Related articles:
Military-related tax links
Survivor Benefit Plan

About Doug Nordman

Author of "The Military Guide to Financial Independence and Retirement" and co-author of "Raising Your Money-Savvy Family For Next Generation Financial Independence."
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7 Responses to IRS Denies Military Retirement “Net Disability Exclusion”

  1. Andy says:

    The PDF letter you are quoting though is posted on the IRS website:

    Click to access 9921043.pdf

  2. vanguard23 says:

    Thanks for highlighting this old post on your FB page. I also do my own taxes (have been doing so since I was a young 1LT when I was “voluntold” to be a Tax Assistance “specialist” at my post’s VITA site) and I wasn’t really aware of this (and it doesn’t apply to me anyway) until you raised this topic on FB. At least I can inform fellow retirees of this “persistent misunderstanding” that could get military retirees in hot water with the IRS.

  3. Casey says:

    This is a great article. My wife found it while I was at work (civilian job). I was baffled while doing my taxes online and looked to be ready to get a nice return. Once I entered my 1099-R into the equation (17 years 9 months service, medically retired), that ‘nice return’ disappeared quickly and I took a $7k hit and now owe money. I didn’t finish my online submission as it was time to do some research. From what I am read, I believe I do qualify and will need to figure out how to apply this appropriately to my taxes.

    Again, I was medically retired because of an injury I sustained and before I reached 20 years of service. I do receive VA disability as well.

    • Doug Nordman says:

      Thanks for your comment, Casey!

      You need to go talk to a tax CPA, and preferably one who is an “Enrolled Agent” with the IRS. I’m not a tax professional, but here’s my opinion:

      You already took a deduction for your VA disability benefits. As the IRS ruling quoted above says, you are not allowed to take a net disability exclusion (a second deduction) based on the same disability.

      It’s possible that you’re one of a handful of people who are eligible to take the net disability exclusion. If that’s true (and I doubt that it is) then you should not take a deduction for your VA disability pay. It’s one or the other.

      If you submit your tax return with both of those deductions then you will trigger a query letter and maybe even an audit.

      There are many other things that could have caused that $7K tax bill. You should check those with a VITA tax-prep site in your area, and maybe they can help figure out the issue. But I can practically guarantee that the net disability exclusion is not the answer.

      Seek professional help before you file your return.

      • Casey says:

        Doug, I am going to schedule a meeting with my HR Block person instead of filing my own taxes this year. I can definitely see what you are saying as far as not being able to take a second deduction on the same disability. I left out a “*” in my previous post that may have helped better define what I was thinking.

        1. I did elect to keep my VA compensation. This ‘should’ deduct the VA compensation automatically from my DFAS payment. The remainder of that is fully taxable. Completely aligned.

        the “*” in this conversation is that I did elect to keep my VA pay; however, through the entire 2014 tax season, DFAS did not deduct this from my pay prior to taxation. They didn’t do it, because it appears to have taken a full year for the VA and DFAS system to link up.

        Being subjected to the way the military works, I was good at just taking that money and setting it in another account until they come back for it……and they will. Now, starting in January 2015, the DFAS payment does deduct my VA payment and then is taxed appropriately.

        2. Based upon what I stated in #1, I would think the following (again, I will schedule with tax person):

        I was overtaxed for my DFAS (retirement pay) as I was taxed on $12k that should not have been taxed (simply because it took a year for both systems to catch up to each other). this is why I believe I am able to take the additional tax break…but could be wrong.

        When it comes time to do my 2015 taxes, it should be pretty standard as my VA compensation is being taken out (as expected) and I am being appropriately taxed.

        On another note. The 7k could be a factor of other items, this is true. I believe I jumped into a different tax bracket this year as my AGI is not the same as last year.

      • Doug Nordman says:

        Thanks, Casey, sounds like a couple of tough returns.

        Please keep us updated for other veterans who may be in similar situations!

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