2010 CCH Whole Ball of Tax
Members of the Military Get Special Treatment At Tax Time
(RIVERWOODS, ILL., January 2010) – One consolation for the hardships of serving in the military is the special treatment members of the armed forces receive at tax time, according to CCH, a Wolters Kluwer business and a leading provider of tax, accounting and audit information, software and services (CCHGroup.com).
“Although many U.S. tax laws apply equally to civilians and members of the military, Congress has also passed many laws to make sure that people don’t suffer from a tax point of view as a result of their military service,” said CCH Principal Federal Tax Analyst Mark Luscombe, JD, LLM, CPA.
Special Rules for Combat Pay
Normally, military pay is taxable. This includes compensation with all sorts of names: active duty pay, reserve training pay, enlistment or re-enlistment bonuses, incentive pay, readjustment pay and travel and per diem allowances.
But pay for service in a combat zone is an exception. All compensation for active service for any month in which a service member serves in a combat zone is exempt from income tax, up to the highest rate of enlisted pay, which was $7,368.30 per month in 2009. So if someone begins service in a combat zone on the last day in January and leaves the combat zone on the first day of December, the entire year’s pay is exempt. A state or local bonus paid to a service member on account of service in a combat zone is also excluded from income.
Up until 2006, combat pay was not considered “earned income” since it is not taxed, and this could lessen eligibility for the earned income tax credit and the child credit. But since then, members of the military can elect to have combat pay counted as earned income for figuring both credits.
Combat Pay and IRAs
The law also now allows military personnel to count combat pay as earned income for the purpose of making contributions to traditional and Roth IRAs, which can only be made out of earned income.
Veterans also are eligible for subsidized mortgages financed by state bonds that are usually available only to first-time homebuyers. Veterans can use these programs even if they have previously bought a home, but they can use them one time only.
Extra Time to File – and Buy a House
Members of the military who are on duty outside the United States or Puerto Rico (but who are not serving in a combat zone) have until June 15 to file their taxes. Interest will accrue from the normal due date until the time of payment, however.
If a service member is serving in a designated combat zone, is deployed in a “contingency operation” or is hospitalized outside the United States because of an injury received while serving in a combat zone or in a contingency operation, the due date of the service member’s return is postponed for the period of the combat service or hospitalization plus 180 days. In addition, no interest or penalties will be assessed.
The combat zone/contingency operation filing extension (which also includes service in qualifiedhazardous duty areas) also applies to other tax-related time limits. This includes such things as paying income and estate taxes, instituting Tax Court proceedings, filing refund claims, making contributions to qualified retirement plans and taking distributions from IRAs.
“Taxpayers should write ‘Combat Zone’ across the top of returns and documents to bring these items to the immediate attention of the IRS or the Tax Court,” Luscombe noted.
Members of the military on active duty outside the U.S. also have extra time to take advantage of the first-time homebuyer’s credit. Although the program expires for homebuyers who do not have a binding contract to buy a home before May 1, 2010 and who do not close on the home before July 1, 2010, those limits are extended to the corresponding dates in 2011 for qualifying members of the military. Qualifying members of the military are also eligible for a waiver of the normal provision that they have to live in a home for three years after purchase to avoid a requirement that they repay the credit.
Death Provides Exclusion
It has long been felt that there is something wrong about taxing the earnings of those who pay the ultimate price in service to their country, so the law provides a total income tax exemption for the earnings of those who die as a result of wounds, disease or injuries incurred in a combat zone.
The exclusion applies to the service member’s entire income, not just military pay, and it applies to the entire calendar year in which the death occurs. For example, income taxes have been abated on a deceased service person’s share in a partnership’s income from the date of death to the end of the partnership’s fiscal year.
The exclusion also applies to prior years, back to the first year of service in a combat zone. This means family members can file amended returns to have prior years’ taxes refunded, although a statute of limitations – usually three years from the normal due date of a return – applies.
Military death benefits, like civilian life insurance proceeds, are now totally tax-free. In addition, for deaths from injuries on or after June 17, 2008, military death gratuities and Servicemembers Group Life Insurance benefits can be rolled over into a Roth IRA or Coverdell education savings account regardless of normal contribution limits to those tax-advantaged savings vehicles.
“This can be a good way to fund a young child’s future college education or to set up a retirement fund, but the penalties for early withdrawal from these accounts still apply,” Luscombe noted. “A young widow or widower should think twice about whether they might need the funds for more immediate needs before committing them to a long-term savings vehicle that carries potential withdrawal penalties.”
The law now provides that certain survivor benefits such as accelerated vesting or ancillary life insurance benefits that would be granted if an employee returned to work and then died must be provided to the beneficiaries of a participant who dies during qualified military service before returning to work.
There is no requirement that plans increase benefits based on time spent on active duty for participants who fail to return to work based on death or disability, but the law now authorizes plans to do that, treating the situation as though the employee had returned to work the day before the death or disability took place.
In 2006, Congress provided a new benefit for military personnel called to active duty. As a result of the Pension Protection Act, those called to serve are allowed to make penalty-free withdrawals from their IRAs, 401(k)s and similar tax-advantaged plans. In addition, they will have two years after the end of their period of service to repay the distribution into the plan, and thus avoid income tax, as well as the 10-percent penalty, on the withdrawal.
“A call to active duty can be a serious financial hardship for a National Guard member with a full-time civilian job or a small business,” Luscombe noted. “This new provision lets them soften the blow by allowing access to otherwise restricted retirement savings. But they will lose tax-advantaged earnings while the money is out of the plan and could face income taxes and penalties if they fail to repay the distribution.”
The liberalized rules only apply to those called to service after September 11, 2001.
In addition, since June 18, 2008, reservists called to active duty have the right to withdraw their funds in a Health Flexible Spending Account.
“Without this provision, reservists might have to forfeit money they had set aside in a Health Flexible Spending Account to pay for medical expenses that now will be covered by the military,” Luscombe said.
Certain special benefits extended to living members of the military and their families aren’t considered taxable income. Dependent care is one of these. The Department of Defense operates one of the largest child care programs in the United States and provides dependent care assistance to members of the Armed Forces. The law makes it clear that these benefits are excluded from income.
Another special program involves military homeowners whose properties decline in value when a base closes or reduces operations. In cases where the government reimburses them for the loss they suffer on the private sale of their homes, the payments they receive are excluded from their income.
There are special rules for the sales of personal residences to take account of the mobile nature of many military careers. In general, single filers can exclude up to $250,000 of gain from the sale of their principal residence while married taxpayers filing jointly can exclude up to $500,000 of gain. But the exclusion is subject to an ownership and use test.
Normally, a taxpayer has to own and use the property as his or her principal residence for at least two years during the five-year period that ends on the date of sale.
But there is a special exception to the two-out-of-five-year rule for uniformed and foreign service personnel called to “qualified official extended duty” – any period of active duty for more than 90 days or for an indefinite time at a duty station at least 50 miles from the taxpayer’s principal residence.
In that case, they can elect to suspend the five-year test period. The maximum length of the suspension is 10 years, and it can only be made for one property. If the election is made, the five-year period ending on the date of the sale of a principal residence does not include any period up to 10 years during which the serviceman or woman, or his or her spouse, is on qualified official extended duty. The election may be revoked at any time.
Help for Students and Reservists
Members of the Reserve and the National Guard can take an above-the-line deduction for service-connected travel expenses in connection with trips that take them more than 100 miles away from home and that involve an overnight stay. The deduction is limited to the general federal per diem rate, which varies by locality.
Students who have received appointments at the United States Military, Navy, Air Force, Coast Guard and Merchant Marine academies and who have savings in tax-advantaged 529 accounts used to be caught in a tax catch-22. Amounts in 529 accounts can only be withdrawn without penalty to pay for educational expenses – but students appointed to service academies technically are being paid for their services and have no educational expenses.
Since the 2003 tax year though, they have been able to withdraw a pro-rata amount from the accounts each year they are in school without having to pay the 10-percent penalty. The amounts withdrawn are included in their gross income, however.
“The theme behind much of the tax legislation pertaining to the military in recent years has been to fix situations in which older tax laws unwittingly had created penalties for people serving their country,” Luscombe noted. “In some cases, if people drafting legislation years ago had given a little more attention to the unique situations of military members and their families, the problems that recent laws try to solve would never have arisen.”
State Rules Vary
The rules for federal taxation of military pay and benefits can be complex, but at least they apply to all uniformly. Not so with the states.
Many states with an income tax use taxable or adjusted gross income from the federal return as a starting point in calculating the state tax. In those cases, items excluded for federal purposes normally also escape taxation at the state level, but not all states follow this practice.
“Some states exempt combat pay, some exempt pay for Guard and Reserve training, some exempt all military pay, some exempt a certain amount and some tax all of it,” Luscombe said. “Fortunately, the web pages for many states’ departments of revenue address how military pay is taxed, but anyone with doubts should consult a qualified tax professional with knowledge of the specific state’s rules.”
About CCH, a Wolters Kluwer business
CCH, a Wolters Kluwer business (CCHGroup.com) is a leading provider of tax, accounting and audit information, software and services. It has served tax, accounting and business professionals since 1913. CCH is based in Riverwoods, Ill. Wolters Kluwer is a leading global information services and publishing company. Wolters Kluwer is headquartered in Alphen aan den Rijn, the Netherlands (www.wolterskluwer.com).
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